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ACCOUNTING FOR 
MODERN CORPORATIONS 


INSTRUCTION PAPER 


PREPARED BY 

WILLIAM M. LYBRAND, 'C.P.A. 

I 

OF THE FIRM OF LYBRAND, ROSS BROTHERS & MONTGOMERY 

AND 

F. H. MACPHERSON, C.A., C.P.A. 

OF THE FIRM OF F. II. MACPHERSON & CO. 

AND 

ARTHUR LOWES DICKINSON, F.C.A., C.P.A. 

OF THE FIRS S OF JONES, CAESAR, DICKINSON, WILMOT & CO-, 

AND PRICE, WATERHOUSE & CO. 


r •> 

i t 
' ' ' 

AMERICAN SCHOOL OF CORRESPONDENCE 

ti 

CHICAGO 

U. S. A. 

------ 


ILLINOIS 















Copyright 1909 by 

American Schooe of Correspondence 


Entered at Stationers’ Hall, Eondon 
All Rights Reserved 














ACCOUNTING FOR MODERN 
CORPORATIONS 

INTRODUCTION 

The history of business development during the last few years 
shows an unmistakable tendency toward the formation of large com¬ 
binations of capital. That such combinations are destined to exert 
a controlling influence on our future industrial progress, seems to be 
a settled fact. 

W here once small manufacturers, operating independently, pro¬ 
duced goods in sufficient quantities to supply the trade in a limited 
territory, the tendency of the more modern plan is to concentrate 
production in large plants located with reference to sources of supply 
and the market for the finished product. The object of this cen¬ 
tralized control of manufacturing industries is, primarily, economy 
of production, coupled with a desire to maintain greater stability in 
the general condition of a given industry. 

Centralized control attains these objects in several ways. Econo¬ 
my of production results from a more even distribution of manufac¬ 
turing orders among the several plants, insuring a more nearly uni¬ 
form rate of production, and the placing of orders with those plants 
best equipped to handle a particular class of work. One plant may 
be equipped to perform certain operations in the process of manu¬ 
facture at less cost than any other in the group. By a judicious 
distribution of orders each plant can be kept running full time on 
work that can be produced most cheaply. The cost of .marketing 
the product is Reduced by a distribution of orders with reference to 
the location of the plants, resulting in lower transportation charges. 
Stability of prices is maintained by a regulation of production at a 
point that will meet all demands but prevent over production. Selling 
costs are lessened because one salesman can cover a given territory 
for the entire group. 

Several plans of organization intended to bring about these con¬ 
ditions have been tried. The most practical of these plans, and the 
one that seems destined to become the accepted plan, is the holding 







2 


M< )DERN CORP( )RATI( )NS 


company. Without combining all plants under the absolute owner¬ 
ship of one corporation, the holding company plan insures centralized 
control through the ownership by the parent company of a majority 
of the stock of the subsidiary company; amounting to a practical 
ownership of the companies themselves. 

The formation of these combinations of capital has brought 
with it new problems in corporation accounting. Since accounting 
of this class is destined to increase in importance, a knowledge of 
the special problems involved and how to solve them has become 
a very necessary part of the knowledge of the accountant. And like¬ 
wise a knowledge of the accounting problems of these enterprises 
is of the utmost importance to the investor, that he may intelligently 
analyze their financial statements and determine the real value of 
their stocks and securities. 

Experience in solving these problems is by no means common, 
even among public accountants. Realizing the importance of the 
subject, and the danger of its being treated in a superficial manner 
if intrusted to an accountant lacking in practical experience, it was 
decided to secure the opinions of some of the best-known men in the 
profession, who are experienced in this very class of accounting. 

The views of three men whose right to be considered authorities 
on this subject is unquestioned are presented herein. Mr. Lybrand 
presents a valuable paper on the subject, “The Accounts of 
Holding Companies;” Mr. Macpherson writes on “Corporation Ac¬ 
counting and Investigations,” illustrated with a worked-out problem; 
Mr. Dickinson presents a paper entitled “The Profits of a Corpora¬ 
tion,” and in his treatment of accounting problems includes an illus¬ 
trative example. 

These papers are submitted as the expressions of men who are 
specialists, and with full confidence in their value to every student of 
business and accountancy. 


t 


THE ACCOUNTS OF HOLDING 

COMPANIES 


1. While it may be true that many of the industrial enterprises 
now in existence remain as partnerships or as independent corpora¬ 
tions, a very large number of undertakings of that character have 
been consolidated into that form of organization represented by the 
holding companies. It is with accounts of the latter class of industrial 
enterprises, therefore, that this paper will deal principally, because 
accounting principles, if sound, do not change with their application 
to any particular form of accounts, while accounting methods, if good, * 
when modified to conform to the requirements of the different kinds 
of business operations, are applicable to small as well as to large 
undertakings. 

POOLS 

2. In the revival of industry which succeeded the industrial 

V 

depression of 1873, the corporate form of organization began to be 
used more and more. The holding company had not then made 
its appearance and the great combinations of the present day did not 
then exist. In the meantime the corporations, not having consolidated, 
and therefore being competitors, were led to adopt various devices 
designed to eliminate the evils of competition from which they suffered. 
The formation of pools was one of the commonest and most popular 
methods employed. The pools were associations of manufacturers 
who agreed to place the marketing of their product under some central 
association, hoping thereby to secure the benefits of stable prices and 
a regulated output. The inherent weakness of the pools was that 
their provisions were not enforceable at common law, and good faith 
on the part of the members could be compelled only by the forfeiture 
of deposits, the imposition of fines and expedients of a similar charac¬ 
ter. Mutual distrust was apt to exist, withdrawal of members was 
possible, and in times of depression, when business at profitable 
prices was hard to obtain, and when the pool was most needed, it wjis 
usually most difficult to control the members or to keep them together. 


4 


ACCOUNTS OF HOLDING COMPANIES 

TRUSTS 

3. The failure of the pools to accomplish the object for which 
they were organized, led to the creation of a iorm of organization 
which was intended to have a legal foundation and a permanent 
existence, namely, the Trust. Under the trust form, the capital 
stocks of the constituent companies were assigned to a board of 
trustees, who issued trust certificates in lieu ot the shares so assigned. 
The trustees, having been vested with the control of the corporations 
through the assignment of their capital stocks, became responsible 
for the management of the several companies and were thus in a 
position to adopt a settled policy in all matters pertaining to the 
limitation of output and the upholding of prices. Ihe trust, as an 
expedient for lessening or obviating the evil of competition, and for 
securing the benefits of consolidation, was by reason of its authority, 
stability and permanent organization a decided advance over the 
temporary and ineffective pool. Its legal position was, however, 
found to be open to attack, and adverse judicial decisions in cases 
brought to test whether or not it was a combination in restraint of 
trade, finally drove the trust out of existence as a legal means of 
effecting combinations. 

HOLDING COMPANIES 

4. About the time the test cases to prove whether or not the 
trust was to be allowed to exist were in progress, a new legal expedient 
for accomplishing combination was provided through the enactment 
by the State of New Jersey of a revised General Corporation Act, 
under which the right was granted to one corporation to purchase 
and hold stocks of another, a right which prior to that time seems to 
have been held by the corporations only by virtue of their being or¬ 
ganized under special laws. It has been said that, “for momentous 
consequences, this statute of New Jersey is hardly equaled in the 
annals of legislation; corporate organization could henceforth be 
promoted, not to serve the ends of industrial management, but solely 
in order that financial combinations might indirectly control operating 
companies through ownership of their capital stock.” Thus the hold¬ 
ing company originated, and under this law one consolidation fol¬ 
lowed another, until at the present time there exist the gigantic in- 


ACCOUNTS OF HOLDING COMPANIES 


5 


dustrial combinations which virtually control the several lines of 
industry in which they are engaged. 

ADVANTAGES OF COMBINATION 

5. The principal factor leading to the formation of the industrial 
combinations was doubtless the desire to eliminate ruinous compe¬ 
tition by obtaining so large a control over any one class of merchandise 
that it was possible virtually to regulate the price at which it could 
be sold. Contrary to the accepted idea, the control of prices does 
not necessarily mean their exorbitant advancement, but under en¬ 
lightened management, exemplified, we believe, in one of the largest 
combinations, it enforces a policy of stability in prices, under which 
business in times of depression suffers vastly less than if indiscrimi¬ 
nate price cutting were in effect. However, other causes than the 
control of prices were instrumental in hastening the formation of 
combinations. In a territory as extensive as the United States, the 
transportation of raw materials to the seat of manufacture, and the 
finished product thence to the place of its disposal, constitutes a large 
element of cost. Under a combination, the orders may be so dis¬ 
tributed that the mills most advantageously situated as respects trans¬ 
portation facilities can be worked to their full capacity, while others 
less favorably’ located may, except in times of unusual activity, be 
closed temporarily. Orders for certain classes of merchandise may be 
concentrated in one plant so that it may run continuously with few 
• changes of appliances, and thus turn out the largest output at a mini¬ 
mum of cost. Sources of raw materials may be controlled through 
the large financial resources of the combination, or by the amalga¬ 
mation with it of the companies controlling such raw materials. 
Labor may be dealt with in larger groups and more advantageously; 
expenses of distribution of goods may be curtailed by dispensing with 
salesmen who traverse each others’ territory; duplicate offices may 
be eliminated; stocks of merchandise may be reduced; management 
and office expenses may be decreased by concentration—these are 
some of the other advantages which it was believed would accrue to 
the properly constituted combinations, and which have in many in¬ 
stances, doubtless been realized to a considerable extent. 





6 


ACCOUNTS OF HOLDING COMPANIES 


EVILS OF MONOPOLY 

6. Without devoting undue space to a discussion of the ethical 
features of trusts or combinations, it may not be inappropriate to 
consider for a moment the evils which in the public mind seem 
to be indissolubly associated with them. First of all is the dread of 
monopoly. To what extent this fear is justifiable it is difficult to 
determine. Even where a combination has a virtual monopoly, there 
is a practical limit beyond which it cannot advance its prices. If 
this limit is exceeded, demand for the article ceases, substitutes there¬ 
for are devised, or the pressure of public opinion becomes so great 
that the most strongly intrenched monopoly must be effected by it. 
On the other hand a monopoly is probably effective in influencing 
prices in that they can be maintained at substantially the same level, 
in the face of reduced costs of production due to the introduction of 
improved manufacturing processes, thus depriving the consumer of 
the benefit of at least a part of the widening margin between cost and 
selling price which would probably accrue to him under the regime 
of competition. It will be argued by others, however, that the greater 
profit results entirely from the economies of combination, and that 
therefore the additional margin equitably belongs to the producer, 
as the consumer, under competition, would have been no better off 
than is now the case. 

At a meeting for the discussion of economic questions, a promi¬ 
nent socialist recently described the material advantages which, he 
argued, would accrue to the workingmen, if the productive agencies 
of the industrial world were placed under their control and operated 
for their benefit. A well-known political economist in reply expressed 
his belief that if these agencies were so controlled and operated, the 
net results under the relatively unskillful management that would 
then ensue would be so much less than under the present conditions, 
that each workingman would receive no more than he does at the 
present time. The same thought may be true as to prices; if under 
competition there is economic waste, and in combination there is 
economy, would not the increase in costs under the former necessitate 
prices equal to those under a monopolistic regime? These questions 
of costs, prices, and monopoly are, of course, too far reaching to be 
properly discussed within the limits of a paragraph, but they are 



ACCOUNTS OF HOLDING COMPANIES 7 

now the source of so much public debate, with the possibility of an 
attempted public control, that they demand our thoughtful con¬ 
sideration. 

The temptations of fraudulent promotion and speculative manage¬ 
ment are other evils ascribed to the combinations. It is claimed that 
earnings which were used as a basis of capitalization have been over¬ 
stated, either intentionally or ignorantly, by the failure to include 
among the expenses of operating the full cost of maintaining the prop¬ 
erty, or a proper provision for renewal of the plant through whose 
operation the earnings were produced, but which must obviously de¬ 
teriorate in value because of that use, or become obsolete through the 
introduction of improved appliances. The more serious charge has 
been made and proved to the satisfaction of many, that constituent 
companies acquired at one price by the members of a syndicate have 
been sold directly or indirectly to themselves as directors of the holding 
company at greatly enhanced amounts. Speculative management, 
with one eye on the ticker, and the other on the profit and loss 
statement, has been alleged, with the attendant evils of a property 
“skinned” to show large earnings, or the payment of dividends 
unearned, or at least unwarranted from the standpoint of financial 
expediency. 

It is alleged that the holding company adds to the complexity 
of corporate organization, admits of the accumulation of debts in the 
affiliated companies, the piling up of deficits in some companies 
without provision therefor in the accounts of the parent company, 
and by other devices tends to obscure the real profits or losses, thus 
leaving the stockholder utterly in the dark as to the actual value of his 
holdings. 

Numerous remedies have been proposed to prevent some of the 
foregoing evils. The trend of public opinion at present seems to be 
toward federal regulation and compulsory publicity. It would appear 
that a reasonable degree of federal supervision, or at least the issuance 
of a federal license to do business, would be welcomed by the larger 
corporations in preference to regulation by the individual states, each 
one imposing different conditions. Publicity, within reasonable 
limits, is rapidly being voluntarily adopted, and it seems reasonably 
certain that corporations conducted as “blind pools” will ultimately 
be relegated to the past. 


8 


ACCOUNTS OF HOLDING COMPANIES 


ACCOUNTS OF A CORPORATION 

7. It was stated at the beginning of this paper that accounting 
principles, if sound, are applicable to any particular form of accounts; 
therefore, with a subject as comprehensive as the one now under con¬ 
sideration, it does not seem feasible to do more than discuss those ac¬ 
counting principles which should control in the inauguration, adminis¬ 
tration and presentation of the accounts of industrial enterprises, 
without attempting to deal with details or to describe the particular 
form which the accounts should assume. 

The accounts of a corporation may be called the history of its 
financial transactions, or, as the writer’s perceptor was accustomed 
to remind him constantly, they should be “records of the facts.” A 
fact would seem to be capable of but one interpretation, and we should 
therefore, if not otherwise informed, be led to expect that a statement 
prepared from the books would be an exact reflection of the facts of its 
financial transactions. But in practice no such simple or ideal con¬ 
dition will be found to exist. The modern business organization is 
so complex, and its transactions so numerous and so varied, that the 
facts are sometimes difficult to ascertain, and frequently are of such a 
character that they fall under the category of opinions rather than 
certainties. Further, the operations of a business are intended to be 
continuous, and at no time is it contemplated that there will be a final 
cleaning up in which every asset will be realized on and every liability 
disposed of; therefore, while the fact as to the current transaction 
may be known, the amount to be ultimately realized may be uncertain, 
and the best that can be done with the accounts is to organize them 
intelligently and administer them on sound accounting principles, 
so that when a statement is prepared it will reflect an honest opinion 
as to the company’s financial position and the results of its operations. 

BALANCE SHEET OF HOLDING COMPANY 

8. The principal accounts of a corporation, or, at least, those, 
which are perhaps of the greatest interest to the management, are the 
balance sheet and the income and profit and loss statement. 

The balance sheet of a holding company is not necessarily a 
particularly complicated statement. If the holding or parent cor¬ 
poration is a finance company simply, as distinguished from an operat¬ 
ing company, its chief assets will usually consist of the securities of the 



ACCOUNTS OF HOLDING COMPANIES 


0 


subsidiary companies of which it is the owner. Quite frequently the 
entire capital stocks of these subsidiary companies will have been ac¬ 
quired by the parent company, and the latter may also be in possession 
of some of the bonds which lie against the property of the subsidiary 
companies. 

Frequently, other large items of assets are advances made to the 
subsidiary companies for which the latter may have issued their notes 
in favor of the parent company. Such advances are usually made to 
provide for extensions or additions to the plants of the subsidiary 
companies after they have been acquired by the holding company, or 
they may have been made for the purpose of furnishing additional 
funds to purchase larger stocks of materials, to carry contracts requir¬ 
ing considerable time to complete, or for any other legitimate business 
purpose. If the moneys advanced have been for the purpose of add¬ 
ing to the plants of the subsidiary companies, it may be that these loans 
will subsequently be funded by the subsidiary companies through the 
medium of mortgage bonds, which if sold to the public will enable the 
subsidiary companies to discharge their debts to the parent company. 
Or possibly, if the whole of the authorized stock of the subsidiary com¬ 
pany is not outstanding, a further amount may be issued and delivered 
to the parent company in settlement of the advances, thus changing the 
form of the asset on the holding company’s books from an account 
receivable to a security ownership. It is improbable that such a 
course would be pursued except in very special instances, as the hold¬ 
ing company would doubtless prefer to appear as a creditor of the 
subsidiary company, rather than as an owner of more shares of its 
capital stock, because, if the subsidiary company were unprofitable 
and it became necessary to wind it up, the holding company would 
claim, with the other creditors, its proportion of the realizations 
from the subsidiary company’s assets. Such a position, we believe, 
would be assumed by the holding company in the absence of direct 
ruling to the contrary, but serious doubt has been cast recently on the 
ability of a holding company to sustain such a contention, where it is 
the owner of the entire capital stock issue of the underlying company. 

Advances made by a parent company to its subsidiary companies 
are not always represented in the latter by tangible property. Such 
advances may have been made to recoup the subsidiary company for 







10 


ACCOUNTS OF HOLDING COMPANIES 


losses sustained by it in operating. The advances appearing on the 
books of the parent company would, under such conditions, be nominal 
assets only, and as such, in a balance sheet of the holding company 
they should be offset by a reserve sufficient to provide for the whole 
or such part of them as may be represented by losses. 

It is probable that among the assets of the holding company there 
will be included capital stocks of companies, a minority interest in 
which may be all that is owned by the holding company, or at most it 
may be a majority holding and not a complete ownership. Unless there 
has been a marked depreciation in the value of such holdings, they 
would be included in the balance sheet at their respective costs, but 
if it is apparent that they have suffered a radical and permanent de¬ 
cline, they should be written down to an amount which will represent 
their actual worth. 

The liabilities usually call for no particular comment, as, if they 
are clearly stated, they will be self-explanatory. The capital stocks 
and bonds issued by the company will generally appear as major 
items, followed by loans payable and accounts payable due by the 
company. It is possible that some of the subsidiary companies may, 
through funding operations, have acquired a temporary surplus of 
cash, which they have deposited with the parent company, and which 
consequently will appear as liabilities of the latter. The other lia¬ 
bilities will include the reserve and sinking fund accounts and miscel¬ 
laneous items. 

9. Consolidated Balance Sheet. The foregoing remarks are 
intended to apply to the balance sheet of the holding company per se. 
It is now very generally recognized, however, that the submission of 
the balance sheet of the holding company only, does not furnish the 
owners of the company with the information as to its real financial 
position to which they may justly consider themselves entitled. 

The holding company was, as heretofore stated, organized for 
the purpose of acquiring the capital stocks of affiliated companies, 
and thus affecting a combination which would bear the test of adverse 
legal scrutiny. While each company under this scheme retains its 
corporate identity, and is in the eyes of the law a separate corporation, 
yet there is a virtual consolidation of ownership, the results of which 
can be properly expressed in a statement of their accounts only by 
consolidating the balance sheets of all the companies into one balance 


ACCOUNTS OF HOLDING COMPANIES 


11 


sheet, eliminating therefrom the inter-company stocks, bonds and 
accounts, which indicate the relation of one company to another, and 
not to the public. 

A consolidated balance sheet therefore is intended to reflect the 
financial position of the whole group of affiliated companies, considered 
as one undertaking. In a typical balance sheet of this character, the 
following grouping of the assets and liabilities has been adopted: 


Assets 

Property Account. 

Deferred Charges to Operation. 

Investments. 

Sinking and Reserve Fund 
Assets. 

Current Assets. 


Liabilities 

Capital Stock of Holding Corpora¬ 
tion. 

Capital Stocks of Subsidiary Com¬ 
panies not owned by Holding Cor¬ 
poration. 

Bonded Indebtedness. 

Current Liabilities. 

Sinking and Reserve Funds. 

Surplus. 


When a holding company purchases the capital stock of another 
company, the price paid for this capital stock presumably represents 
the holding company’s estimate of the value of the equity in the sub¬ 
sidiary company’s asset. This price may be greater than the com¬ 
bined capital stock and surplus account of the subsidiary company, 
in which event the difference must be assumed to denote the value o: 
the subsidiary company’s goodwill, or other assets not appearing on 
its balance sheet, otherwise, if they were included there, the cost of 
the capital stock to the holding company would be exactly equal to the 
combined capital and surplus of the subsidiary company. On the 
other hand, if the price paid by the holding company, for the capital 
stock of the subsidiary company, is less than the combined capital 
and surplus, the difference must be assumed to express the amount at 
which the assets of the subsidiary company are overvalued on its 
books. 

In consolidating the “Property” accounts of the subsidiary 
companies (their property accounts including goodwill, trademarks, 
franchises, etc., as well as tangible property), the total must, there¬ 
fore, be increased or reduced by as much as the cost of the capital 
stocks of the respective subsidiary companies, as at the date of their 
purchase by the holding company exceeds or falls below their com¬ 
bined capital and surplus account. 





12 


ACCOUNTS OF HOLDING COMPANIES 


It might seem at first thought that the surplus accounts of the 
subsidiary companies should not be applied as stated in the foregoing 
paragraph, but that they together with the surplus accrued subse¬ 
quent to the purchase by the holding company, should be combined, 
and their aggregate entered on the consolidated balance sheet as the 
surplus of the whole undertaking. The fallacy of this statement has 
been proven in various ways. Perhaps the most simple and direct 
argument is somewhat along the following lines: the surplus of a cor¬ 
poration, generally speaking, represents the balance of earnings which 
have accumulated from its operations, and which have not been paid 
out to the stockholders, applied in immediate reduction of valuation 
of assets or reserved for the ultimate replacement thereof. As a sur¬ 
plus can accrue only during the operating of a company, it is fairly 
obvious that the holding corporation prior to its organization cannot 
have earned such a fund, and that therefore it would be entitled to 
merge into its consolidated surplus account only the balances of profits 
accumulated by the subsidiary companies during the period of their 
ownership by the holding corporation. 

Further, as the amount paid by the holding company for the 
capital stock of a subsidiary company represents the holding com¬ 
pany’s estimate of the equity in the subsidiary company, and as that 
equity is presumed to be represented by its capital stock and surplus 
account, it follows that in the process of consolidating, the capital 
stocks of the subsidiary company in the holding company’s books will 
be eliminated, as will be the capital stock and surplus account on the 
subsidiary company’s books. The surplus account being thus ab¬ 
sorbed, cannot of course, appear again as a surplus in the consolidated 
balance sheet. 

10. Inventories. The consolidation of the other items of assets, 
which would be included under the groups noted on a previous page, 
will probably call for no particular comment, except in the case of the 
inventories. Some of the industrial enterprises of the present day 
begin their ownership with the raw materials, and manufacture their 
output all the way from the first stage to the last. Necessarily this 
manufacturing cannot, in every instance be performed in one con¬ 
tinuous operation or by one plant, and there will be constant transfer 
from one company to another of product finished up to a certain point, 
but subject to further manipulation in order that it may be disposed 


ACCOUNTS OF HOLDING COMPANIES 


13 


of in a different form. At the end of the fiscal year or other balance- 
sheet period, there will doubtless be a quantity of such merchandise 
in the inventories of the several subsidiary companies, purchased by 
one company from another at a price greater than the actual cost of 
manufacturing. As the companies are entirely distinct from each 
other, it may be argued that the purchasing company will be justi¬ 
fied in including such merchandise in its inventory, at the price paid 
to the company from which it was acquired. The purchase, however, 
having been made by one subsidiary company from another, is in 
effect merely a transfer from department to department of virtually 
the same corporation, and not a sale on which the profit can be said 
to have been realized. The principle that profits must not be antici¬ 
pated would seem therefore to be applicable in such instances, and it 
would follow that a reserve should be provided equal to the amount 
by which such merchandise at inter-company prices exceeds its actual 
manufacturing cost. 

Too hard and fast a rule should not be drawn, however, even 
when conditions are such as have been outlined above. In the case 
of an iron and steel combination, for instance, controlling the manu¬ 
facture of its products from the ore in the ground to the sale of the 
finished merchandise, it will be appreciated that there are a number 
of points in the process of manufacture, where the merchandise 
reaches a finished and marketable stage. While at each stage in the 
manufacturing process some of the merchandise is sold to outsiders, 
much of it is transferred to other mills for further manipulation at a 
price which includes some profit to the subsidiary company by which 
it was handled. Is it entirely unreasonable to claim that where the 
manufacturing processes are distinct and complete, some manu¬ 
facturing profit shall be taken in the current income account on mer¬ 
chandise finished by one company, but remaining in the inventory 
of another company while awaiting further transformation. In the 
balance sheet of a large industrial enterprise, such profits are applied 
as a separate part of the surplus account, distinct from the ordinary 
accumulation of surplus, with a note appended setting forth clearly 
the nature of the item. 

11. Capital Surplus. In the organization of many corporations, 
it has been the practice to issue bonds or stock equal to the amount at 
which the property purchased is offered by the vendors, and accepted 







14 


ACCOUNTS OF HOLDING COMPANIES 


by the directors, subject to the cash requirement of the state in which 
the corporation may have been chartered. In addition, a sum of 
money is sometimes provided by the vendors for working capital, or 
a certain number of shares of stock may be turned back into the com¬ 


pany’s treasury, to be sold and the proceeds used for the same pur¬ 
pose. It has been held by the legal profession, that inasmuch as the 
property purchased, for which the company’s securities were issued, 
has been declared to be of a reasonable value and necessary for the 
purposes of the corporation, any contribution which may be made by 
the vendors is in the nature of a donation, and as such is surplus or 
profit to the company. While technically, this may be true, yet prac¬ 
tically it cannot be a profit, first because a corporation cannot earn a 
profit before it has begun operating, and second, such a return of 
cash or securities on the part of the vendors is really in the nature of 
an abatement of the purchase price, and as such would be deductible 
from the cost of the property acquired. It has been held, that if the 
item is noted as capital surplus or designated by some synonymous 
expression which will clearly distinguish it from the surplus accumu¬ 
lated out of the earnings during the operation of the company, this 
will be sufficient, but it would seem to be more logical to apply it as a 
reserve or as a deduction from the cost of the properties purchased. 

12. Subsidiary Company Balance Sheet. In preparing the 

consolidated balance sheet from the holding company’s and subsidiary 

companies’ balance sheets, it is, of course, essential that the latter 

shall have been correctlv stated. 

*/ 

The first item or group of assets in the subsidiary company’s 
balance sheet that claims attention will be the account or accounts 
representing the fixed assets owned by the corporation, which may 
appear under the inclusive title of “Property” or which may be entered 
under the several captions of land, buildings, machinery, goodwill, 
franchises, etc. 

As long as the present method of capitalizing on the basis of 
earnings is in vogue, and the property acquired by the new corporation 
is valued at a lump sum, it is improbable that a separation thereof 
will be made into accounts which will show the value of its land, 
buildings, and other tangible assets, apart from the so-called “water.” 
So much loose talk has been indulged in respecting the evils of over- 
capitalization, as to lead to the idea in the mind of the public that the 


ACCOUNTS OF HOLDING COMPANIES 


15 


whole difference between the value of the tangible property and total 
of the property account is “water” only, which ought to be squeezed 
out. 

That there is water in many of the stock issues, no one will deny. 
Capitalization has been determined in many instances, not on earnings 
reasonably certain of realization, but on prospective earnings of years 
to come, or on economies of combination and profits of monopoly 
that could not possibly be realized. But when the capitalization of 
a concern is based on an average of earnings, and fixed at such an ag¬ 
gregate sum that reasonable dividends may be paid, proper reserves 
provided, and a sufficient surplus accumulated, then it can hardly be 
said that it is overcapitalized, even though the value of the tangible 
assets may not measure up to its capitalization. The difference be¬ 
tween the two simply measures the then value of the goodwill,' patents, 
trademarks, franchises, or other intangible assets of the company, 
but such assets in a case of that kind cannot be considered as “water.” 
As long as the business continues under conditions not less favorable 
than at its beginning, the intangible assets will retain their value. If 
the business fails, their value will probably disappear, as will also 
disappear the major part of the value of the so-called tangible assets. 
The worth of each depends on the continuance of the business, but 
as it is contemplated that a business will continue there is a real equity 
existing in such a case which cannot be ignored or of which the owners 
cannot justly be deprived. 

. There is, however, a strong tendency at the present time to at¬ 
tempt, with respect to the railroads at least, an appraisement of their 
physical property to ascertain how it compares with their capital 
obligations. How far reaching this movement may prove to be can¬ 
not be foreseen, but it may not be unsafe to predict that ultimately 
the capitalization of corporations taking over a going business will 
represent the actual tangible property plus what the results of past 
operation will show to be a reasonable amount for goodwill, franchises, 
etc. When that time is reached it will likewise doubtless be required 
that the balance sheet shall set forth separately each class of property, 
and the valuation at which it was acquired. 

13. Charges to Fixed Asset Accounts. In the consideration of 
accounts of land, buildings, and machinery, arises numerous questions, 
respecting depreciation, obsolescence additions, improvements, etc., 


J 


1G 


ACCOUNTS OF HOLDING COMPANIES 


all of which have a direct bearing on the balance sheet in (hat the 
proper valuation of the said assets therein depends on the correct 
solution of these questions. It is necessarily difficult to dissociate 
them from the income account as well, because that account will like¬ 
wise be affected according to the way these questions are decided. 

With respect to items which may properly be considered as capital 
expenditures, it has been suggested as a working basis that no additions 
should be made to the property accounts unless it can be clearly shown 
that they have increased the earning capacity of the plant. A simple, 
positive rule such as this might be all that is required, if the changes 
in the plant and the resulting increase in earning capacity were occa¬ 
sioned only by actual extensions or additions of property which had 
never before existed. But such is not the case. In every progressive 
manufacturing concern, alterations or additions to the plant are con¬ 
stantly being made for the purpose of simplifying- the manufacturing 
processes and thereby increasing the output with the same expendi¬ 
ture for labor and materials, or in order to decrease those operating 
charges which are in the nature of overhead expenses required to be 
taken up in the cost of the product. As no alteration or addition to 
a plant is probably ever undertaken except for the purpose of increas¬ 
ing the earning capacity thereof, directly or indirectly, the literal 
application of the rule referred to is not possible, and it will be neces¬ 
sary to consider the nature of the various alterations, improvements, 
and additions, before an intelligent decision can be made as to their 
ultimate disposition. 

. At the outset, it may be conceded that actual extensions or ad¬ 
ditions to plant which did not exist before, will be properly chargeable 
to capital account, assuming that such additions do not render 
useless an existing but less efficient plant producing a similar kind of 
product. 

The large class of expenditures consisting not of certain definite 
additions, but rather of alterations and improvements, is more difficult 
to deal with. In the case of improved appliances displacing less 
efficient ones, it has been held that the latter should be written off and 
the former added to the property account. Technically, this would 
seem to be correct, and ii there is a direct saving in operation, or a 
relative increase in output, this course would seem to be justifiable. 
But if the new appliances are required in order to cope with a com- 


ACCOUNTS OF HOLDING COMPANIES 


17 


petitor having like facilities, or to meet the demand of the trade for 
improved articles at the same price, it would be more conservative to 
consider such additions as having the nature of extraordinary renewals, 
whose cost would be charged off within a reasonable period through 
the depreciation or renewal reserve appropriations. 

Improvements to the plant which indirectly tend to simplify 
manufacturing processes or to lessen fixed operating expenses would 
also technically be chargeable to capital account, but a conservative 
application would call for their absorption in the current profit and 
loss account. 

In so far as the records of the foregoing expenditures are con¬ 
cerned, it is clear that the cost of each should be clearlv set forth in the 
accounts, distinct from ordinary renewals and repairs. If one is 
furnished with a brief explanation of the improvement, the saving 
sought to be accomplished by its use, the cost of the improvement and 
the cost of the property displaced, it is possible to decide intelligently 
whether the item should remain as a permanent capital addition, be 
absorbed through a renewal reserve fund, or be charged off immediately 
in the current year’s operations. 

iV discussion as to whether or not specific amounts should be 
written off goodwill, franchises, patents, trademarks, etc., would, 
under present conditions, probably be little more than academic. 
Nevertheless, the policy in force in the most conservatively managed 
of the large corporations of absorbing a part of their earnings in adding 
to the physical property, is in effect a writing off of such intangible 
assets. If continued for a sufficient number of years, the additions to 
the property charged against the surplus account, would ultimately 
take the place in the property account of the goodwill, franchises, etc., 
so that the property account would consist of tangible physical assets 
only. Assuming that the accounts have been kept in such a manner 
as to show clearly the cost of the additions so written off this practice 
is to be commended. The stockholders thereby become accustomed 
to these charges against the profits, and are less likely to demand 
larger dividend distributions, while the application of the earnings 
to the improvement of the property tends to maintain the earning 
power, admits of continuity and stability in dividend disbursements, 
and prevents to a considerable extent violent fluctuations in the market 
values of a corporation’s securities. 


18 


ACCOUNTS OF HOLDING COMPANIES 


14. Deferred Charges to Operations. In the development of 
a corporation’s property and in connection with its current operations, 
there are frequently certain expenditures made of such a character 
that they are not justly chargeable immediately to the operating costs, 
nor on the other hand should they be included with the permanent 
property or the current assets. Instances of important items of this 
class are advance payments of royalties and costs of exploration and 
testing preliminary to the development of properties containing raw 
materials. Other examples of relatively less important items are 
unexpired insurance premiums, rentals paid in advance, prepaid 
discounts, etc. Advance payments of this character are usually 
found grouped under the caption of “Deferred Charges to Operations,” 
the purpose being to carry them temporarily as assets, and then charge 
them off to the operations of the periods during which the benefit of 
the expenditures is reaped. 

In addition to expenditures which are without doubt chargeable 
against future operations, there are certain others which are not so 
clearly defined, but which may with some degree of reason, be included 
therein. Business operations of certain kinds run in seasons—that 
is, during spring and early summer the whole effort of the sales de¬ 
partment and to some extent the administrative forces, may be en¬ 
gaged in booking' orders for delivery during the winter. Before 
the winter delivery begins the end of the fiscal period arrives, with 
the result that there will appear among the expenses of the fiscal 
period, a large amount incurred directly in connection with the next 
season’s output. It would seem, under such conditions, not unreason¬ 
able to carry over such expenses as deferred charges, and write them 
off during the succeeding year. It may be argued that the expenses of 
of one season will offset another, and that it is easier to absorb such 
items in the operation of the fiscal period during which they happen 
to have been incurred. This is unquestionably the more conservative 
method, but in the event of the transfer of the business at any fiscal 
period, there is an equity existing not shown on the books, which 
must be taken into consideration. 

Occasionally a corporation, perhaps engaged in the manufacture 
of some patented or trademarked article, may inaugurate a campaign 
of advertising, in which it is proposed to concentrate in one year the 
ad\ ei tising that would usually be spread over two or three years. 


ACCOUNTS OF HOLDING COMPANIES 


19 


Here again it may be claimed with some show of reason that a part 
of the advertising cost should be carried over to be charged off in the 
following years. If there is a reasonable prospect that the effect of 
the advertising will continue during the succeeding one or two years, 
probably no valid objection could be made to such action, provided 
it is done in good faith. 

Discounts on bonds have, in the past, usually been considered 
a proper charge to capital, and as such have been added to the cost 
of the property. The price at which a bond may be sold depends 
primarily on the rate of interest paid and on the security afforded. 
If the security is unusually good the rate may be low and the bond still 
sell at par; if the security is good but not unusually so, and the rate 
fairly low, the bond will sell at a discount; if the security is poor the 
bond will sell below par, even though the rate is high. The cost to the 
corporation of obtaining funds from the sale of its bonds therefore de¬ 
pends largely on the assurance which it can afford the investors that the 
interest payments will be maintained and the principal paid at maturity. 
Convinced of these two factors, the selling price of the bond becomes 
to a considerable extent a matter of interest rate. If the rate is high 
the bond should sell at a premium, in which event the company will 
receive a sum in excess of the amount it will eventually have to repay, 
and this excess sum or premium will in effect act in reduction of the 
the high interest rate. If the rate is low and the bond sold at a dis¬ 
count, the company will he obliged to bear the expense of the interest 
and ultimately also the difference between the realization from the 
bond and its par value— i. e., the discount. A discount on a bond is 
therefore an adjustment of the interest rate, and as such should be 
spread over the term of the bond, the balance not charged off to be 
carried in the meantime as an asset of the deferred charges class. 

15. Liabilities. In stating the consolidated liabilities, few 
questions of principle are likely to be encountered. Under capital 
stocks will be included the stock issues of the holding company, and, 
separately stated, such part of the stocks of the subsidiary companies 
as are not owned by the holding company. The balance of the 
capital stocks of the subsidiary companies, being virtually inter-com¬ 
pany accounts, will be eliminated in the process of consolidating. 

The bonded debt of the holding company, as well as that of the 
subsidiary companies, whether guaranteed or not by the holding 


20 


ACCOUNTS OF HOLDING COMPANIES 


company, will appear, excepting that bonds of the subsidiary com¬ 
panies owned by the holding company will be eliminated, as it is the 
purpose of the consolidated balance sheet to show the financial posi¬ 
tion of the affiliated group of companies with respect to the public 
and not to each other. 

10. Sinking Fund. A sinking fund for the redemption of bonds 
is in effect a surplus accumulation because the fund is not disbursed 
for current expenses, but is used merely to retire liabilities, thereby 
increasing the stockholders’ equity in the property. The usual sinking 
fund provision requires, however, that a stipulated amount shall be 
provided out of the profits each year, hence it is necessary that a 
transfer of the required amount be made from the profit and loss 
account to a sinking fund reserve. If the sinking fund theory is 
carried out, funds equal to the amount so transferred will either be 
paid over to the trustees, placed on deposit and earmarked as being 
for sinking fund uses, or invested temporarily until required for the 
redemption of the bonds. If the value of the property on which the 
bonds were based is maintained without impairment, the sinking fund 
accumulation will, when the bonds are redeemed, properly revert to the 
surplus account; but if the property is of a wasting character and has 
depreciated in value to substantially the same amount that the sinking 
fund account has accumulated, then the latter is really in the nature 
of a depreciation reserve and should be so applied. 

•The investments made out of sinking fund accretions and the 
unexpended balances of cash will appear among the assets under the 
classification of sinking and reserve fund assets. Bonds redeemed 
by the trustees of the sinking fund will be applied among the liabilities 
in reduction of the respective bond issues in which they originated, 
the effect being to show under the funded debt liability onlv the 
balance actually outstanding. 

17. Reserve Accounts. It is quite likely that among the liabili¬ 
ties will be found, in addition to the sinking fund accounts, numerous 
reserve accounts accumulated out of current profits or surplus, to 
provide for renewals or replacements of plant, losses by fire or acci¬ 
dents, shrinkages in receivables, and for any other contingency which 
may arise. 

With respect to these reserves which are collected as a prepara¬ 
tion against fire losses, accident claims, bad debts, etc., there are 


ACCOUNTS OF HOLDING COMPANIES 


21 


probably no accounting principles involved which merit particular 
attention. Experience will, no doubt, have demonstrated in each 
of these cases the amount which should be set aside from year to year 
to cover losses arising therefrom. It is true that unusual and unex¬ 
pected losses may be incurred through fires or accidents, but if the 
reserves therefor are based on sound principles, the amounts set 
aside and the losses charged against them ought to be fairly equal 
during a series of years. Even if this should prove not to be the case, 
the losses from such sources admit of being definitely ascertained 
after they have been incurred, and the reserve accounts may then be 
adjusted accordingly. If the reserve is more than exhausted the 
balance should be written off and not carried forward with the hope 
that during the succeeding period the losses may be so small that the 
account will be recouped. 

18 . Depreciation. When the subject of reserve for depreciation 
and renewals is approached, discussion thereof is attempted by the 
writer with some hesitation. Books and pamphlets are being pub¬ 
lished thereon, the best accounting thought of the country is being 
directed thereto, Federal and State accounting authorities are strug¬ 
gling with the problem, and the whole matter seems at present to be 
in a formative state. Happily, material progress has been made in 
that the fact of depreciation is now generally admitted, whereas it 
was formerly strenuously denied or at least ignored. Once there is 
brought home to the management a realization of the absolute neces¬ 
sity of providing reserves for the depreciation or obsolescence of their 
property, it leaves open only the question of determining the methods 
and rates by means of which the reserves will be accumulated. 

Depreciation may be defined as the impairment of the value of 
an asset by reason of wear and tear. Exception has frequently been 
taken to the recommendation that a charge be made against the 
profits to provide for depreciation, on the ground that the repairs 
and renewals charged to operating have been sufficient to maintain 
the effectiveness of the asset unimpaired. In the case of business long 
established, which is managed along conservative lines as respects 
charges to capital account, and which maintains its plant at a high 
level of efficiency, it is probable that the renewals charged to operating 
will aggregate an amount substantially equal to that which would 
be considered a fair charge for depreciation. So far then as the 





00 


ACCOUNTS OF HOLDING COMPANIES 


statement of profits or losses of a particular period is concerned, there 
would then be no material difference in the results, if the deprecia¬ 
tion charge were substituted for the renewal costs, and the latter 
applied against the depreciation reserve fund previously created, 
assuming that the renewals were fairly well equalized from year to 
year. From the standpoint of the balance sheet, however, such a 
method is unsatisfactory, in that there will then have been made 
no provision for accrued depreciation, with the result that the assets 
will appear at cost, notwithstanding the fact they must have 
deteriorated in value because of wear and tear. 

Further, during the earlier years of an enterprise when the plant 
is new, the maintenance and renewal costs will naturally be much 
smaller than will be the case when the effects of its use are being felt, 
and if no charge is made against the profits for depreciation, there 
will be a virtual overstatement of profits and possibly an excessive 
distribution of dividends, which will have to be made good in one 
way or another later on. 

It may be argued that when an enterprise is in its infancy its 
earning power will naturally be small, and therefore the charges made 
against it for future provisions should be correspondingly light; the 
theory being that the increase in profits will be sufficient to meet the 
cost of the renewals as they become necessary and still leave the 
net earnings unimpaired, while the enhancement in the value of the 
enterprise as a whole, due to the larger earnings, will offset any accrued 
depreciation that may exist. While this was doubtless true of some 
of the earlier enterprises, notably the street railways, its continued 
application is fraught with danger. Combinations of undertakings 
Which have themselves been established for some time, are certainlv 
not new enterprises in the sense that they are about to cultivate a 
virgin field, from which they anticipate the reaping of increasing 
profits. Assuming that additional profits are realized through the 
consolidation, they have usually been more than anticipated, and 
the charges against them have been fixed accordingly. It would 
therefore seem to be extremely unsafe for a combination of industries 
to fail to provide liberally for accrued depreciation, and in the mean¬ 
time to pay out practically all its earnings in dividends, on the ground 
that the increase in profits from year to year will be sufficient to take 
care of the necessary renewals and replacements. 


ACCOUNTS OF HOLDING COMPANIES 


23 


A more important factor than wear and tear in determining the 
effective life of an operating asset is that of obsolescence. Buildings 
or machinery are seldom abandoned because they are worn out. 
Usually long before that condition is reached they have become 
antiquated or otherwise so unfitted to cope with current require¬ 
ments that their effective life is at an end, notwithstanding their 

7 t_5 

actual condition may still be good. In making provision for the 
renewal or replacement of an asset, obsolescence, as well as wear 
and tear, must therefore be taken into consideration. 

If the life of a property were maintained merely by ordinary 
repairs, its value would decrease year by year until it arrived at the 
scrap stage, if in the meantime it had not become obsolete. Provision 
for renewal under such conditions would be based on an estimate 
of effective life, which had regard only for the factors of diminishing 
value due to ordinary wear and tear, and possible obsolescence. But 
in practice, it will be found that a property does not lessen in value 
from year to year in regular gradations. When a part of the plant 
reaches a comparatively ineffective stage, it is quite likely that it may 
be substantially rebuilt and perhaps positively improved by the addi¬ 
tion of new devices, so that it practically begins a new lease of life, 
and its effective existence is correspondingly lengthened. The ques¬ 
tion then arises as to whether the provision for renewal shall be 
sufficient to cover the cost of the property spread over the life term 
thus augmented, and the cost of rebuilding or renewal, or whether 
the reserve shall have regard only for the first cost of the item, leaving 
the rebuilding or renewal charges as they occur to be taken care of 
in current operating. 

The former has been suggested as the correct method, since 
charges against operating will otherwise be less each year than should 
be the case except in those years when the rebuilding or renewal 
takes place, during which periods it would be excessive. 

The practical objection met with will doubtless be that it will 
be very difficult to estimate with any degree of accuracy the probable 
cost of rebuilding and the length of the augmented life term; also, 
that having estimated these factors and established a reserve fund, it 
will be equally perplexing to distinguish between repairs which should 
be charged direct to current operating, and renewals which are charge¬ 
able against the reserve fund. 

O 



24 


ACCOUNTS OF HOLDING COMPANIES 


It is impossible to lay down any hard and fast rule which will 
apply to all cases. Industrial statistics respecting renewals and de¬ 
preciation covering any considerable period are probably not yet 
available, and changes in manufacturing methods have been so 
frequent up to this time, that obsolescence would seem to have been 
the determining factor in limiting the life of a plant unit, rather than 
depreciation due to wear and tear. 

As to the value and term on which to estimate the renewal re¬ 
serve charge, would it not be reasonable, at least for the present, to 
endeavor to estimate the life of a machine or other part of the property, 
on the assumption that it will continue to be used in the same form as 
when acquired, in the meantime being maintained by ordinary repairs, 
but not rebuilt or redesigned; then over such estimated life term, 
spread the first cost of the machine. If a machine is rebuilt, the value 
that has been exhausted will presumably have been provided for 
through the renewal reserve. The first cost of the machine may there¬ 
fore be reduced by the renewal provision, and the cost of rebuilding 
or a part thereof added, thus arriving at a new valuation for the re¬ 
juvenated appliance, on which a new estimate of life will be made 
and for the exhaustion of which a new renewal reserve will be pro¬ 
vided. At the best, the depreciation reserve charge will be an estimate 
and one can hardly do more than use the best information available, 
exercise good judgment, and make the appropriation in good faith, 
with a due regard for conservatism. 

AlS to the expenditures chargeable to operating as ordinary re¬ 
pairs, and those properly applicable to the reserve fund provided for 
renewals, there will also be a divergence of opinion. It might be 
laid down as a working rule, that if the operation of a machine or 
other property unit is discontinued in order that it may be overhauled 
thoroughly, and substantial parts replaced or improved devices added 
so that -only minor repairs will be necessary for a long time to come, 
such work would constitute a renewal or rebuilding, the cost of which 
would be chargeable against the fund. 

19. Income of Holding Company. The income of the holding 
company is derived principally from dividends on the stocks of the 
subsidiary companies owned by it. If the dividends declared by the 
underlying companies whose operations have been profitable exhaust . 
substantially all their earnings for the fiscal period, and if the provision 


ACCOUNTS OF HOLDING COMPANIES 25 

is made in the holding company’s accounts for losses incurred by 
those underlying companies whose operations have been unprofitable, 
then the net income account of the holding company will show cor¬ 
rectly its profit for the fiscal period which may be under consideration. 

From the point of view of the stockholder, however, an income 
statement so prepared is unsatisfactory, while from the standpoint 
of the directors, such a form is inadvisable because it does not dis¬ 
close the information that it is reasonable to assume should be fur¬ 
nished to the owners, and in the case of reckless or dishonest manage¬ 
ment it paves the way for manipulation. 

Since the major part of the income will be derived from dividends 
of underlying companies, it would be quite possible for them to de¬ 
clare dividends which more than exhaust their earnings, and which 
encroach upon the surplus earned during a previous period, or accumu¬ 
lated prior to their acquisition by the parent company. In either 
event, a dividend under such conditions would not represent the 
earnings of the year, and the income of the holding company would 
therefore be overstated to the extent that the dividend exceeds the 
current earnings of the underlying company. On the other hand, 
if the operations of the subsidiary companies have resulted unfavor¬ 
ably, the withholding from the income account of a reserve for the 
subsidiary company’s losses will also result in an overstatement of 
the holding company’s profits. The understatement of the profits 
would, under such conditions, also be quite feasible. Further, the 
very much condensed exhibit of net earnings which appears in the 
income account of the holding company, provides the stockholders 
with no data relating to the gross receipts, operating expenses, fixed 
charges, appropriations for reserves, and other matters pertaining 
to the administration of the group of companies of which they should 
be informed in order to judge intelligently as to the efficiency of the 
management. 

20. Consolidated Profit and Loss Account. It is therefore 
generally recognized by accountants that as the consolidated balance 
sheet should be substituted for the balance sheet of the holding com¬ 
pany, there should likewise be submitted a consolidated profit and 
loss account in place of that of the holding company. 

Most of the comment that is applicable to the consolidated 
balance sheet is pertinent to the consolidated profit and loss account. 







26 


ACCOUNTS OF HOLDING COMPANIES 


In the- consolidated profit and loss account transfer of profits from 
subsidiary companies to the holding company, through the medium 
of dividends, will be ignored, and the earnings, expenses, and charges 
of the several companies will be combined and stated as though the 

corporation were one enterprise. 

In the consolidated statement, therefore, will appear the entire 
gross earnings of the group of affiliated companies. Such gross earn¬ 
ings will represent cumulatively the operations of the several under¬ 
lying companies—•?. e., merchandise transformed into a marketable 
condition by one company and transferred to a second company for 
further manipulation and sale in a different form, would appear in 
the gross earnings of each company, and their aggregate in the con¬ 
solidated profit and loss account. While on the surface it would seem 
that there is a duplication of gross earnings under this method, it is 
probably the only practical way in which to state them where there 
is a large number of companies with very many manufacturing pro¬ 


cesses. 

Again, as the property accounts of the various subsidiary com¬ 
panies are consolidated in the balance sheet, it would seem that the 
gross operations of those companies should likewise be aggregated 
in order to show the relation of the volume of business to the property 
investment. 

From such gross earnings will be deducted the entire operating 
costs incurred in producing those earnings, the balance resulting 
being then subject to the addition of income of a miscellaneous nature, 
and the deduction of expenses which are not applicable directly to 
the manufacturing and producing operations. 

In stating the consolidated income and profit and loss account, 
there will probably be some difference of opinion as to the point at 
which charges other than for ordinary operating should rest, in order 
that the current net earnings of the undertaking may be shown. It 
is fairly clear that from the gross earnings must first be deducted the 
costs in labor, materials, and operating expenses, incurred in produc¬ 
ing those earnings, in order that what we shall call a manufacturing 
profit may be shown. It is true, that in industrial enterprises, in¬ 
cluding mining, land and water transportation, as well as many forms 
of manufacturing, such an expression is in a sense a misnomer, but 
as the mining and transportation are really tributary to the manu- 




, ACCOUNTS OF HOLDING COMPANIES 


27 


factui'ing, the title may stand. It is true also that there are so many 
different kinds of products, with varying rates of profits, included 
in the gross earnings, that comparatively little use can be made of 
the figures as a basis of comparison from year to year. Nevertheless, 
as it is impossible in a condensed statement to show the volume and 
profit of each line of business, the aggregate figures will give the stock¬ 
holder some information as to the total business, and, in a rough 
way, the rate of profit thereon for comparison with preceding periods. 

From the gross profit so ascertained, should be deducted the 
administrative, selling and general expenses, virtually common to 
the whole enterprise, and chargeable against the operations as a 
whole. The resulting balance would be subject to adjustments be¬ 
cause of extraordinary items relating to operating, but which cannot 
be included fairly in the current operating costs; and by income from 
investments, other than those representing the holding company’s 
ownership of the subsidiary companies. 

At this point it would seem that the profit and loss account as 
such should rest, the resulting balance being a profit or loss that may 
be said to represent the operating earnings or losses of the group for 
the fiscal period. These figures are the ones with which those in¬ 
terested in the enterprise are most concerned, as they reflect the 
rising or falling prosperity of the company. 

The balance then carried forward from the current profit and 
loss to the income or general profit and loss account will be reduced 
by reason of reserves for depreciation, replacement, sinking fund 
requirements, etc., which are properly appropriated out of current 
earnings. Logically, such items should be deducted before the balance 
of current profits is struck, because the depreciation and replacement 
reserve at least are charges directly connected with operating, but 
as heretofore remarked, depreciation statistics are not sufficiently 
accurate, and the practice of reserving for depreciation is not yet 
common enough to justify the inclusion of such charges with the 
ordinary operating costs. Further, if they are stated separately, 
attention is drawn to the fact that reserve for depreciation has been 
made, and to the amount of that provision. 

The balance of profits, after deducting the foregoing reserves, 
shows the position of the earnings with respect to the interest payable 
on the debt of the subsidiary and holding companies. It may be 



28 


ACCOUNTS OF HOLDING COMPANIES 


held that interest on bonds of subsidiary companies (being a lien 
which must be deducted by the subsidiary company from its earn¬ 
ings before it can appropriate the remainder to the holding company) 
should be applied before the balance of current earnings is shown. 
It is suggested, however, that it is preferable to embrace all of the 
interest on the funded debt of the companies in one group, in order 
that the total thereof may appear; also because the bonded debt 
of the subsidiary companies may change by reason of new securities 
of the holding company being issued in lieu thereof, or it may be re¬ 
duced through the operation of the sinking funds, in either of which 
events the interest charge would be lessened, and a comparison of 
operating profits from year to year disturbed. 

After the deduction of interest on the bonded debt, the balance 
remaining represents the profits available for dividends. The ad¬ 
visability of distributing it in dividends is another matter, however, 
and if the management is conservative, a large sum will doubtless 
be applied towards new construction work, thus, as has already been 
remarked, “squeezing out the water,” or, to put it more fairly per¬ 
haps, replacing the intangible assets with tangible physical property. 

21. Monthly Balance Sheet. The accounts of a corporation 
are intended to disclose the company’s position as respects its debtors, 
its creditors, and its owners. 

Its relations to its debtors arise through the charges made to them 
for the sales of its products, or from the debits of various kinds. Its 
liability to its creditors is created through the purchase from them 
of moneys, services, and materials, required in the conduct of its 
business operations. No abstruse accounting theories are involved 
in either of these two relations, as their ascertainment is dependent 
only on the correct use of the proper means. 

The accounts which exhibit the company’s position as respects 
its owners, or their representatives, the management, are more in¬ 
volved, and for that reason the discussion in this paper has been 
limited substantially to accounting problems or principles relating 
to these internal accounts. 

Not many years ago it was considered that if the results of the 
operations oi a business and its financial position could be shown 
once a \ear, or, at most, at the end of semi-annual periods, a more 
frequent statement was not necessary. When business units were 


ACCOUNTS OF HOLDING COMPANIES 


29 


much smaller than at present, competition less keen, and the number 
of those interested in each enterprise fewer, such a practice was fairly 
satisfactory, although there were apt to be surprises in store when the 
results of the fiscal period were disclosed. 

In this present era of huge enterprises, however, a year, or even 
six months, is too long to conduct a business without knowing definitely 
the result ; therefore, each month the management requires that there 
be placed before it statements showing how the company stands, and 
what it has earned or lost. Hence there have been introduced the 
monthly balance sheet and profit and loss account. 

In preparing these monthly reports, it is, of necessity, essential 
that accrual accounts of various kinds shall be established, by means 
of which such expenditures as interest, taxes, insurance, and items 
of a similar character, which are paid at more or less infrequent 
intervals may be “spread” equitably over the year’s operations and 
only the proper proportions of each appear in the monthly statements. 
No particular difficulty will be encountered with respect to these 
charges, as it will be quite possible to determine them with reasonable 
accuracy. 

22. Stock Accounts. The part of the work that occasions the 
most embarrassment and the one in which the possibility of error is 
greatest, is the ascertainment of the monthly inventory of the company’s 
product finished and in process, and its current materials and supplies. 
It is comparatively easy to formulate a plan for handling stock ac¬ 
count's, by which the unused or unsold balances of materials and pro¬ 
duct may be shown from time to time, but the practical application 
of the scheme will be much more difficult. 

In theory, all that is necessary is that accounts shall be kept with 
the several articles, singly or in groups, into which accounts will be 
charged all of the items purchased or made at their cost, while out of 
the account will be credited those used or sold at the same average of 
cost, the balance representing those remaining on hand and their cost. 

Assuming that proper allowance is made for waste, and that suit¬ 
able provision is made for obsolete merchandise or for shrinkages in 
value, the remainder would be the inventory value which would be 
included in the balance sheet. In practice, it will be found that many 
possibilities of error exist, and that eternal vigilance is necessary if the 
book inventory is to be accepted as correct. 




30 


ACCOUNTS OF HOLDING COMPANIES 


Materials stored m large quantities may lose in weight or value; 
some are of such a character that the manufacturing operations will 
not permit of the ascertainment accurately of the quantities used Irom 
time to time; others, while nominally under the control of the stock- 
keeper, may be physically located in various parts of the plant, and 
when used may not be reported; stock clerks may be careless and 
issue materials without making a record thereof; in these and many 
other ways errors occur which disturb the correctness of the book 
balances. While it may be admitted that only a certain percentage 
of efficiency can be expected in stock accounts, nevertheless the in¬ 
formation obtained from them and the saving effected through their 
use, far outweigh the possible weaknesses. If kept with reasonable 
accuracy they show the quantity of each kind of supplies or product 
on hand from time to time and thus tend to limit overbuying, while 
at the same time directing attention to merchandise in danger of be¬ 
coming obsolete; they discourage waste by requiring accountability, 
either by bringing the physical control of the materials under the 
storekeeper, or at least under his supervision, so that when used they 
become a matter of record; they are virtually indispensable if correct 
cost accounts are to be kept, and they are essential in preparing the 
monthly balance sheet. 

23. Cost Accounts. Closely associated with the stock accounts 
and the monthly reports of operations are the cost accounts. While 
the matter of cost accounting is still in a formative state, it must be 
recognized that great progress has been made in this department of 
accounts within the last few vears. It has doubtless been the ex- 

%J 

perience of every one, that, being called upon to audit the accounts of 
a manufacturing concern, the accountant might during the course of 
his work discover that in some corner of the office or shop, there were 
being kept some mysterious books which purported to be cost accounts. 

- Not the slightest trace of this system would be found in the general 
books of account, and no attempt was made to reconcile or test the 
results shown by the cost accounts with those appearing in the com¬ 
mercial books. As a result, the cost accounts would sometimes show' 
that large profits were being earned, but when the commercial books 
were closed, this alleged profit would melt away in some strange 
fashion, until the balance might even be upon the other side. 

As* the necessity of securing accuracy in cost accounting became 


ACCOUNTS OF HOLDING COMPANIES 


31 


more apparent, it was recognized that a cost system conducted upon 
practically a single entry basis throughout was unreliable, and that, 
it should dovetail into and be controlled by the general books of ac¬ 
count. Hence, in the modern system of costs, instead of the stock 
records, the cost system and the general books of account being carried 
on as independent groups, they interweave one with the other and 
thus become what may truthfully be called a system. 

It is impossible to frame a cast-iron system that will be applicable 
to every line of business, and one should beware of attempting to 
make the business fit the system, rather than adapting the system to 
the requirements of the business. Where the manufacturing units 
are large, it may be relatively easy to keep the cost of each, charging 
thereto the materials used and the labor spent in constructing it, to¬ 
gether with its proportion of the general expenses. When the articles 
are small and the number of each large, it will be feasible to ascertain 
the cost in lots only. 

Probably no great difference of opinion will exist with respect to 
the items which should be included in that part of the cost made up 
of materials and direct labor. As to materials there is usually no 
doubt, but in the case of labor there is sometimes a twilight zone be¬ 
tween productive and non-productive labor, which makes it difficult 
to determine how they shall be apportioned. As a general proposi¬ 
tion, it is perhaps safe to say that all labor that can be definitely identi¬ 
fied as belonging to a particular piece of work, should be charged 
thereto, but -no rule can be formulated that will cover every case. 
Wages of foreman or laborers might in one instance be classified as 
productive, if the operations were such that they were limited exclu¬ 
sively to one piece of work at a time, whereas ordinarily such expendi¬ 
tures would be included in the non-productive classification. 

The proper distribution of the so-called “overhead” expenses 
is one problem that causes the accountant much anxious thought. A 
large manufacturing establishment has many departments, in some of 
which are used machines costly to purchase and expensive to operate; 
while in others the equipment may be limited to small tools, represent¬ 
ing a small investment and occasioning but little expense in their 
operation. 

The productive labor in the first instance may be small in pro¬ 
portion to the cost of maintaining and operating the equipment; while 








32 


ACCOUNTS OF HOLDING COMPANIES 


in the latter case the reverse would be true. If the combined expenses 
of the two departments are distributed on the basis of direct labor, it 
will manifestly result in the one case in charging too little to the cost, 
while unduly loading it up in the other. However, when all of the 
product of the factory passes through substantially all the depart¬ 
ments, the productive labor basis is perhaps the most convenient and 
equitable way of apportioning the expenses. An excessive charge in 
one department will be corrected when the product reaches the next 
stage, so that in the end a reasonably correct distribution will have 
been made if the volume of work is fairly uniform and the expenses 
do not fluctuate violently. A concern manufacturing small tools 
which successively pass through the forging, grinding, polishing, and 
handling departments, might be cited as an example of the foregoing 
method. 

The distribution of departmental or machine group expenses 
on the basis of the productive labor of each department or group of 
machines might be used advantageously in the case of a concern 
whose manufacturing processes are relatively simple, and whose prod¬ 
uct passes from the raw material to the finished stage with com¬ 
paratively few rests. 

If the manufacturing processes are complex and the cost of each 
part at every stage must be ascertained, the machine rate basis is prob¬ 
ably the most accurate method of apportioning the expenses. Under 
this plan the cost of maintaining and operating each machine tool is 
determined as accurately as possible, the number of hours it will be 
used under normal conditions estimated, and then the resulting rate 
per hour is assessed on each piece of work passing through the machine. 


CORPORATION ACCOUNTING 
AND INVESTIGATIONS 

24. Preliminary to taking up the question which has been 
placed in my hands, as the basis of this paper, I think it well that we 
should give consideration to the principles involved in an examination 
of the accounts of concerns where amalgamation or consolidation is 
being discussed. 

The nature and extent of the accountant’s investigation will de¬ 
pend, of course, largely upon his instructions; but we will assume 
that manufacturing concerns in the same line of business contemplate 
consolidation; that the report of the accountant upon each of the 
plants is to form the basis of the consolidation, and that the account¬ 
ant’s instructions are general and not specific; and that they include 
the determining of the assets and liabilities as well as the earnings. 

Accountants differ as to the scope of an investigation. There 
tare those who take the position that the accountant is not expected 
to make the thorough examination that a regular audit would entail, 
but that the genuineness of the books and of the balance sheet should 
be assumed. Most accountants, however, believe that the investi¬ 
gating accountant should analyze the accounts thoroughly, in the 
doing of which, fraud, if any, would be discovered. 

Regular audits and special investigations have, or ought to have, 
the same end in view—the obtaining of a correct statement of facts. 

ACCOUNTANT’S REPORT 

25. I cannot well see how an accountant can accept and pre¬ 
pare a report from any balance sheet without satisfying himself by a 
sufficient analysis of the regularity of the accounts and of the methods 
followed by which the various items which enter into the assets of a 
concern, or which go to make up the revenue and expenditure ac¬ 
counts, are produced. 

Statements covering each of the concerns examined should be in¬ 
cluded in the report of the accountants independent of each other, 





34 


CORPORATION INVESTIGATIONS 


and based upon the specifications which have been set out, should 

contain information as follows: 

(1) Assets, as of a given date (the same in each instance), divided as to: 

(a) Realty. 

(b) Plant and machinery. 

(c) Merchandise (raw material). 

(d) Merchandise (in process). 

(e) Merchandise (finished product) 

(/) Leasehold. 

(g) Goodwill. 

( h ) Patents. 

( i ) Accounts receivable. 

(j) Bills receivable. 

(/c) Cash on hand and in bank. 

(l) Bills receivable under discount (indirect). 

(m) Accrued interest, insurance, etc. 

(n) Such other divisions of the assets as the nature of the business may 
demand. 

(2) Liabilities, as of a given date (the same in each instance), divided as to: 

(a) Bills payable. 

(b) Accounts payable. 

(c) Mortgage indebtedness. 

(d) Bills receivable under discount (indirect). 

(e) Other indirect liabilities. 

(/) Capital account. 

( g ) Such other division of the liabilities as the nature of the business may 
demand. 

(3) Revenues and Expenses of each business showing earning power of each 
in a given time (usually three years if the business has been in operation 
so long) and preferably covering the same period. 

Taking the items in these divisions in their order, the accountant will ordinarily 
not be called upon to verify items a to h, the land, buildings, stock in-trade, 
leasehold, etc., being specially valued by independent valuers. If not, 
and these are subject to verification by the auditor, he should in the case of: 

(a) Realty. Call for the title deeds and see that the account is not 
charged with fictitious increases in value, or with the annual taxes, as 
I have found in certain instances. 

( b ) And that a sufficient allowance has been made for depreciation (in 
buildings, etc.). 

(c) , ( d ), (e) Merchandise, raw, in process, and the finished product. Get 

certified inventories, which should be checked both as to extensions 
and additions; an independent appraisement is altogether preferable. 
Compare inventory with invoices in the case of raw material. To 
see that profits are not anticipated, a careful inspection of cost ac¬ 
counts is required. In case of manufactured stock care must be exer¬ 
cised to see that office and selling expenses are not pro-rated and 
added to the costs of goods appearing in the inventory. Note should 
be taken of the “dead wood” in the stock and that proper allowance 
has been made to cover. 


CORPORATION INVESTIGATIONS 


35 


(/) Leasehold is not usually a consideration, but if found to exist, a 
special valuation to ascertain present value is best; otherwise, the 
original cost, less proportionate reduction for the expired period 
should be taken. 

(<j) Goodwill. This item can only be determined by agreement between 
the parties, and is one which does not seriously concern the accountant, 
except that if it is put in at an arbitrary sum by the vendors, he should 
see to it that the price be set forth separately and distinctly in the 
“assets” so that the purchasers may know just how much they are 
expected to pay. 

(/<) Patents. See that these are entered at their proper present worth 
—which will be determined by the remaining life thereof, and the 
present “state of the art” in that particular connection. 

O Accounts receivable. A careful examination should be made to as¬ 
certain the condition of these, that they are alive and collectible, and 
that proper provision has been made for bad and doubtful; also that 
secreted in the accounts receivable may not be found charges for 
“goods on consignment” billed out at the usual profit and going 
to swell the volume of output, thus unduly increasing the earnings 
by the “anticipation of profits.” 

0) Bills receivable. Same examination as in the case of accounts, so 
far as prospects of realization are concerned. 

( k) Cash on hand and in bank. The same verification as in a regular 
audit. 

(0 Bills receivable under discount. This is an indirect asset as well as 
an indirect liability, and it Is important in the case of an amalgama¬ 
tion, where the liabilities are being assumed, that information on this 
point should be given. It may be necessary that some allowance 
should be made in anticipation of “loss upon realization.” 

( [m ) Accrued interest, insurance, etc. That the claim for these is fair and 
proper. 

Turning next to the question of liabilities, we take up: 

(a), ( b ), Bills payable and accounts payable. The verification will be the 
same as in a regular audit. In this connection it may be proper to 
say that there is not much danger of the liabilities being overstated. 
The principal danger lies in the understating or not taking to account 
of the outstanding liabilities, and this must be carefully guarded 
against, if the transfer of the business involves the assuming of all 
the liabilities. 

(c) Mortgage indebtedness. Verification by the obtaining of a state¬ 
ment from the mortgagees, both as to principal and arrears or accrued 
interest. 

(d) Bills receivable under discount. The remarks under item l in assets 
would properly apply here, being applicable in both cases. 

( e ) Other indirect liabilities. These may be in the nature of endorse¬ 
ments (although a strictly improper and illegal proceeding in the case 
of joint stock companies) claims for damages, disputed accounts for 
materials, services or commissions. A distinct statement in writing 
as to the existence or non-existence of these should be obtained from 
the proper officers of the company. 


3G 


CORPORATION INVESTIGATIONS 


(/) The value of the business to the purchasers will be represented by 
the difference between the assets and liabilities in each case and if 
profitable should equal the issue of capital stock with an addition 
to the assets of any undivided profits, which would enchance the 
value of the equity to be transferred to the amalgamation. 

SPECIAL POINTS INVESTIGATED 

2G. The question of revenue and expenses of operation will in 
all probability more particularly occupy the attention of the account¬ 
ant, rather than the ascertaining of the value of the assets and liabili¬ 
ties; in fact, as I have stated before, his instructions may limit him to 
the determining of these without regard to the other. Taking the 
revenue accounts first: the accountant will require to make a careful 
investigation of the receipts for the period (usually three years) under 
examination. He will see that no extraneous revenue has been in¬ 
troduced and that the progress in the revenue account has been con¬ 
sistent and steadv, or otherwise. He must be watchful that the 
revenue account has not been increased by credits for goods “on con¬ 
signment” with an off-setting entry to accounts receivable. 

Other points which require to be looked into are: that goods 
“on approval” likely to be returned to stock afterwards have not 
found their way into the sales account; that fictitious sales, for the 
purpose of swelling the revenue have not been put through the books, 
and shipments not made before close of inventory; that incompleted 
and unshipped orders have not been credited to sales account, thus 
inflating revenue by ungained profits; that rebates and allowances 
are a charge against sales and not an addition to merchandise account. 
In a word, the bona ficles of all sales especially near the end of the 
period should be determined to the satisfaction of the accountant. 

It is the duty of the accountant to see that all the expenses entered 
are a proper charge against the business and that they are made within 
the proper period; that there is no reduction in expenses towards the 
close of the term under inspection; that the expenses are regular and 
consistent and bear a steady ratio to the turnover; that proper and 
reasonable allowances have been made for repairs and renewals, and 
that these are charged against revenue and not as an increase of 
capital. 

Excessive profits from any particular cause should be noted, as, 
ior instance, those which might arise from the making of heavy pur- 


CORPORATION INVESTIGATIONS 


37 


chases in anticipation of an upward tendency in prices, and which 
anticipation had been fulfilled. He should be satisfied that all profits 
earned and taken to account are incidental to the business. A sale 
of real estate not required for the purposes of the business, and made 
at a substantial profit, forms an example. On the other hand ex¬ 
penditures of exceptional and unusual character which have gone to 
reduce the profits below normal should be noted. 

In the consideration of the cost of operation heed should be given 
to the effect which a limited capital has had upon the expenses of 
operation. Lack of capital is naturally followed by increased borrow¬ 
ings, and increased borrowings augment the interest account. Oper¬ 
ation is thus charged with a sum, which, had adequate capital been 
invested, would have been in the nature of a dividend. By way of 
illustration, I have in mind a business in which every dollar of capital 
invested was borrowed. This may appear an extreme case, but such 
is, nevertheless, sometimes to be found. The borrowed capital repre¬ 
sented $100,000. Upon this sum interest was paid out of the business 
and charged to operating expenses. I am asked to investigate and 
find this condition. In the preparation of the profit and loss account 
I eliminate the $6,000 interest paid on this sum in order to arrive at 
the earning power of the business. It can readily be seen how unfair 
any other course would have been, and how lack of sufficient capital 
in any business will impair the earning power and affect the showing 
as to profits, unless allowance be made therefor. There is no room 
here for the exercise of a display of good judgment on the part of the 
auditor in determining what the “adequate capital” should be. 

Reports in detail upon each business should be prepared and 
furnished the principals, and these should form the basis upon which 
the amalgamation is carried out. Regard, of course, will also be had 
to the introduction of other interests where more extensive operations 
are contemplated by the amalgamating company. 

FORM OF CERTIFICATE 

27. In.addition to the report in detail a certificate is usually 
prepared for use in the prospectus. This certificate is generally barren 
of all information except as to the revenues, expenses of operation, and 
profit-earning power of the various businesses entering the amalgama¬ 
tion, and these in the aggregate. Indeed, certificates are not uncom- 


38 


CORPORATION INVESTIGATIONS 


moil where information is given only as to the profits earned by the 
several businesses. It is unusual to see any reference to the amount 
of capital invested. It occurs to me that a model certificate would 
be one framed somewhat after the following style: 

CERTIFICATION 

Gentlemen—I beg to advise that I have examined the records of The 
Brown Manufacturing Company, Limited, and of the Jones Manufacturing 
Company, Limited, each for a period of three years, and certify to the correct¬ 
ness of the underwritten statements, as to Capital, Earnings, Expenses of Opera¬ 
tion, and Net Earnings, covering the period given: 

Brown Manufacturing Co., Limited 

Net Capital Earnings Expenses of Net Earn- 

Employed Operation ings 

1898 . $. S. $. $. 

1899 . 

1900 .\ 


Total.. S.. $. $. 

Jones Manufacturing Co., Limited 
Net Capital Earnings Expenses of Net Earn- 
Em ployed Operation ings 

1898 . S. $. $. $ . 

1899 . 

1900 . 


Total. . 


1898 

1899 

1900 


S... $. 

Combined Companies 


Net Capital Earnings Expenses of 
Employed Operation 

S. $. $. 


$ 


$ 


Net Earn¬ 
ings 


Total.. $. $. % . $. 

For further information reference is made to my reports in detail here¬ 
with. 


John Thompson, 

Accountant. 

I fully appreciate that the less detail there is in the report the 
better, for the obvious reason that much of it would not be understood 
by the average individual, and the tendency would be to befog rather 
than enlighten, and that is very undesirable. But I do think that an 
accountant issuing a certificate framed as above, with a simple quali¬ 
fying reference to a report for further and detailed information will 
be placing himself upon safe and sure ground. 




























































CORPORATION INVESTIGATIONS 


39 


EXAMPLE 

Illustrative of the fact that the ground which I have covered up 
to this point includes practically all that is necessary in connection 
with the examination of the accounts for the purposes mentioned, I 
now present for your benefit a memorandum of agreement, which was 
the basis of a recent consolidation with which we had to do. 

BASIS OF CONSOLIDATION 

A corporation is to be formed under the laws of the State of Michigan, 
with a paid-up capital of ten million dollars, to be apportioned into six per 
cent preferred stock and common stock, as the parties interested may hereafter 
determine. 

This corporation is to purchase all the assets, property, goodwill, etc., 
of all the four companies and to pay therefor in preferred and common stock 
and by an assumption of the indebtedness of each company. 

The amount of preferred and common stock, to be paid to each com¬ 
pany, to be determined by the value of the net tangible assets and the valua¬ 
tion placed upon the earning power of each company. 

In placing a value upon the tangible assets, same to be reached as follows: 

(1) The land, buildings, machinery, tools, and patterns, to be determined by 
appraisers, to be chosen by a majority of the committee made up of one 
appointed by each of the companies; on failure of this committee to agree 
on appraisers the selection to be left to the committee who present their 
suggestions. 

(2) Inventories of raw materials, work in progress and manufactured stock 
to be taken, and valuations placed thereon by the individual companies, 
and this to be done under the supervision of a disinterested party, to be 
named by the committee. 

The inventories are to be made as of the same date, and to be taken at 
substantially the same time. 

When completed the inventories are to be passed and agreed upon by a 
committee consisting of a representative of each of the companies and 
one to be named by the committee. The decision of these five to be bind¬ 
ing. 

(3) In reaching the value of the earning power of the several companies, con¬ 
sideration is to be given to the following details: 

(а) That profits are incidental to the business and have not been antici¬ 
pated . 

(б) To the charging to operating expenses of items, exceptional or un¬ 
usual, and which have had the effect of reducing profits below normal. 

(c) The effect upon the earnings of the money paid out as interest upon 
borrowed capital, in case it be found that the borrowings (loans) made 
by the several companies are disproportionate to each other. 

(cl) That all charges to operating expenses are proper charges against 
the business and that they are made for and during the proper period. 
(e) That proper and reasonable allowances have been made for repairs 
and renewals and that these h^ve been charged aga'nst earnings. 


40 


CORPORATION INVESTIGATIONS 


(/) That charges against earnings for depreciation are adjusted upon an 
equitable basis. 

(g) Such other matters as appear from an examination of the accounts 
and which would prejudicially affect the earnings of any of the com¬ 
panies, either advantageously or disadvantageous^. 

( h ) The value of the earning power to be determined by a consideration 
of the business done by each of the several companies for the three 
years, 1903, 1904, and 1905. 

(i) Accountants to be selected by the committee and questions -which 
may arise as to treatment of various matters and about which there 
is difference of opinion, to be determined by the committee. 

(/) All costs and expenses incurred in making appraisals, examination 
of accounts, or of performing the other duties in connection with the 
formation of the proposed new company to be charged to and borne 
by the new company; should the new company not be formed, then 
such costs, expenses, and disbursements to be borne by the four in¬ 
dividual companies in proportion to the number of men employed by 
each. 

A. C. P. A. PROBLEM 

28 . We will now take up the question which I have been asked 
to work out. 

This question evidently originated in the State of Pennsylvania, 
as I should assume, from the fact that reference is made to the payment 
by the corporation, of taxes, etc., due the State of Pennsylvania on the 
formation of the corporation. To make this question applicable to 
that state, I have included instead the franchise fees required under 
the laws of the State of Michigan, which are paid to the Secretary of 
State upon the basis of one-half of one mill upon each dollar of the 
authorized capital stock. Following is the question: 

PRACTICAL ACCOUNTING 

The following statement of affairs which was taken as being correct, was 
made to the proposed underwriters for the consolidation of four corporations, 
under a corporation to be formed to take over all the four corporations. 

It was understood and agreed that the stock of Corporation No. 1, par 
value of which $100.00 should be purchased at $135.00 per share. 

Corporation No. 2, Stock per $100.00 at $120.00 per share. 

Corporation No. 3 “ “ 50.00 at 50.00 per share. 

Corporation No. 4 “ “ 25.00 at 41.00 per share. 

It was also agreed by the underwriters that they would advance sufficient 
money to purchase said stock, the whole of the stock of the proposed corpora¬ 
tion to be turned over to them, together with $200,000.00 of the bonds of the 
new company. 0 


CORPORATION INVESTIGATIONS 


41 


That sufficient bonds is issued to retire the bonds of the old corporation 
and provide for $500,000.00 of treasury bonds to be used in betterments. 

In addition to the above it was agreed that the underwriters would 
purchase at least $250,000.00 of the new bonds at 85%. 

It was agreed also that the par value of the stock of the new corporation 
should be $100.00 per share, and that sufficient stock should be issued to cover 
20% more than the cash outlay of the underwriters for the purchase of the 
stock of the old corporations. 

It was also agreed that the new corporation should take over the assets 
of the old corporations, but that each of the old corporations should be clear 
of indebtedness except for bonds issued. 

The assets turned over to the new corporation were to be as follows: 

Corporation No. 1 


Cash. 

Plant. 

Supplies. 

Book % Receivable 


$ 48,000.00 
450,000.00 
90,000.00 

184,000.00 $772,000.00 


Boflds.. 350,000.00 

Capital Stock. 350,000.00 $700,000.00 


COPORATION No. 2 

Cash. 

Plant. 

Supplies. 

Book % Receivable.. 

Capital Stock. 

Bonds. 


i 70,000.00 
820,000.00 
80,000.00 

270,000.00 $1,240,000.00 
850,000.00 

390,000.00 $1,240,000.00 


Corporation No 3 


fooU . $ 28,000.00 

Plant .* ’ ’. 420,000.00 

Supplies. 42,000.00 

Book % Receivable. 135,000.00 


$625,000.00 


Bonds. 280,000.00 

Capital Stock . 350,000.00 $630,000.00 


Corporation No. 4 

» 

Cash... 

Plant.. 

Supplies. 

Book % Receivable. 

Capital Stock. 

Bonds. 


$ 110 , 000.00 
1,475,000.00 
86,000.00 
432,000.00 

150,000.00 

1,890,000.00 


$2,103,000.00 

$2,040,000.00 


































42 


CORPORATION INVESTIGATIONS 


Form the new corporation with sufficient stock and bonds, the bonds to 
draw 5% interest, to meet the requirements of this agreement, charging into 
plant a/c all taxes and fees due to the State of Michigan, on formation of the 
corporation, together with a counsel fee of $20,000, as well as other compen¬ 
sation under this agreement, and give a statement showing the result. 

At the end of the year it is found that $250,000 of the bonds of the 
corporation have been sold to the underwriters and used for betterments. 

The results of the business for the first year show a profit of $1,000,000, 
.after charging off 10% for depreciation on plant. 

Declare such a dividend as in your judgment is reasonable, crediting 
surplus with whatever balance remains, and give a statement of condition, 
using your own figures in ascertaining the profit. 


I 


SOLUTION 




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MANUFACTURIN G .TRADING, AND PROFIT AND LOSS ACCOUNT. 

DR. Ill CR. 


COUP* (RATION INVESTIGATIONS 


4<> 




































































































































































PROFITS OF A CORPORATION 


DEFINITION OF PROFITS 

29. In the widest possible view, profits may be stated as the 
realized increment in value of the whole amount invested in an under¬ 
taking; and, conversely, loss is the realized decrement in such value. 
Inasmuch, however, as the ultimate realization of the original invest¬ 
ment is from the nature of things deferred for a long period of years, 
during which partial realizations are continually taking place, it be¬ 
comes necessary to fall back on estimates of value at certain definite 
periods, and to consider as profit or loss the increase or decrease be¬ 
tween any two such periods. Hence, it follows that, as stated in Buck¬ 
ley’s treatise on the English Companies’ Acts, ‘‘the ascertainment 
of profit is in every case necessarily a matter of estimate and opinion. 
* * * The legitimate way is to take the facts as they actually stand 
and after forming an estimate of the assets as they actually exist” (and 
presumably, although it is not so stated, of the liabilities) “show a 
balance so as to ascertain the result in the shape of profit and loss.” 

This definition would permit any business concern to revalue 
periodically the whole of its assets and liabilities and to record the 
difference between its surplus so ascertained at the commencement and 
the end of the year as its profit or loss, respectively; and provided that 
this estimate were fairly and reasonably made, there would be no ob¬ 
jection to such a course. In other words, every appreciation of assets 
is a profit, and every depreciation a loss; and in many private con¬ 
cerns this method, technically known as “Single Entry,” of ascer¬ 
taining profits has been regularly adopted for years without bad 
results. A corporation, however, being endowed by statute with 
special privileges is subject to special restrictions, among others that 
of a definite fixed capital stock upon which dividends are declared out 
of the profits of the undertaking. Hence, the consideration of profits 
as applied to a corporation involves the consideration also of the limita¬ 
tions placed either by law or by sound principles of accounting upon 
their distribution as dividends. It is in the legal interpretation of the 
term profits of a corporation (which has come to mean profits available 


48 


CORPORATION PROFITS 


for dividends), and in die distinction between the strictly legal and 
conservative accounting view of the principles upon which they should 
be ascertained that the difficulties of the subject chiefly lie. 

LEGAL PRINCIPLES 

30. The law, represented mainly by Case Law, has consider¬ 
ably modified the definition given above; and as up to the present 
time a larger number of cases have been decided and more definite 
results arrived at by the English than by the American Courts, it will 
be useful here to consider briefly the present condition of the 
English Law on the subject. The decisions given there have been 
based on the principles of Common Law rather than on statutes 
relating to corporations, and these decisions are freely quoted in 
American text books, which, though in slightly different form, appear 
to arrive at substantially the same conclusions. The summaries 
which follow are given with some hesitation in view of the difficulty 
of extracting definite principles from a number of more or less con¬ 
flicting decisions, but they will at any rate serve to illustrate the diffi¬ 
culties which have to be met. 

31. English Law. The regulations of a corporation in England 
usually provide that no dividends shall be paid except out of profits 
arising from the business of the corporation. In order to carry on its 
business a corporation requires certain capital or fixed assets, which 
must be maintained in a reasonable state of efficiency as long as the 
business continues; while its profits or losses arise from the employ¬ 
ment of its fixed assets in continuously changing the condition of its 
current or circulating assets from one form to another, and consist of 
the difference between the realizable value in the final and in the 
original condition, subject to deduction of the cost of the change and 
the expenses of realization. 

Changes in the value of capital assets are not generally realizable 
during the continuance of the business, and hence in the determination 
of profits available for dividend under the above regulation no incre¬ 
ment in the value of its capital assets can be considered; but it would 
seem to be legally permissible to divide among stockholders as divi¬ 
dend a realized profit on the sale of a fixed asset if there were no de¬ 
preciation on other fixed assets to be made good. On the other hand, it 
is not necessary to charge trading profits with any decrement of value 


CORPORATION PROFITS 


49 


not due to causes arising directly out of the business; but any waste of 
fixed assets taking place in the operation of deriving profits out of the 
circulating assets must, generally speaking, be made good out of 
profits. There is, however, an exception to this rule when the con¬ 
stitution of the corporation contemplates the investment of its capital in 
certain specified wasting assets—such for instance as mines—and its 
regulations do not call for any provision out of profits to replace this 
waste by means of a sinking fund or otherwise; in such cases the English 
Courts have held that there is no legal obligation to charge the waste 
against profits earned from the operations. But this exception does 
not cover depreciation of capital assets due to wear and tear which 
has not been, but must at some future date, be repaired if efficiency 
is to be maintained. In the case of circulating assets the position is 
different. The enhancement in the value of these assets being the 
source of the profits of the business, it is necessary and the law requires 
that they shall be maintained intact, and that only the surplus realiz¬ 
able in excess of the amount invested is profit; or, conversely, that any 
deficit is a loss. 

The exact distinction between capital and current assets depends 
necessarily on the nature of the business of the corporation. What 
are capital assets for one business may be current assets for another, 
according as the business of the corporation is to make a profit by 
using them continuously in their existing shape or by converting them 
into some other shape. For instance, if a corporation owns invest¬ 
ments for the purpose merely of collecting the dividends thereon, and 
dividing these among its stockholders, it is not legally bound to make 
good out of profits a fall in the value of the investments. But if its 
business were to traffic in investments, or if it were in fact trafficking 
in them, any fall in value would be a loss, and any rise in value a 
profit, chargeable or creditable to profit and loss. 

Apart from the distinction between capital and current assets, 
the following legal principles would seem to be fairly established: 

The ascertainment of profit being necessarily a matter of estimate 
and opinion, all that is required is that the estimates be fairly and 
honestly made without any fraudulent intention or purpose of de¬ 
ceiving anyone, and that they conform to the constitution of the cor¬ 
poration. 

The payment of interest to stockholders before any profits have 


CORPORATION PROFITS 


50 


been realized is stated to be ultra viresj but interest paid on borrowed 
capital employed in the construction of the works, and in the mean¬ 
time unproductive, may be properly chargeable to capital account, 
and it is perhaps doubtful (although there appears to be no decision 
on this point) whether under such circumstances interest might not 
be paid to stockholders and charged to capital if the regulations 
expressly provided therefor. 

It also seems probable that a corporation having made a loss 
on the operations of the previous years, and commencing the year 
with a deficit in its circulating capital, may legally distribute dividends 
to its stockholders out of current year’s profits without making good 
such deficit. In one decision on this point a deficit of previous years 
is treated as a loss of capital assets, and it is stated that the capital 
having been lost a distribution of subsequently earned profits cannot 
be a payment of dividend out of capital that had been previously lost. 

32. American Law. The general law of this country as laid 
down in the chief text books is based as before stated to a considerable 
extent on the English Courts referred to above. 


Dividends can be paid only out of profits—that is, out of the 
net increase in the original investment after deducting from the assets 
all present debts and making provision for future or contingent claims 
reduced to their present value. But in arriving at this increase the 
permanent or fixed capital may be valued at the price actually paid 
for it, although at the time of estimating said increase it could only be 
sold at a loss. All that is required is that the whole capital originallv 
contributed by the stockholders shall be put into the business and 
kept there, and that no part of it shall be taken out again directly or 
indirectly and given back to them. On the other hand, any deprecia¬ 
tion due to wear and tear arising out of the use of the fixed assets must 
be made good out of the earnings before the surplus can be applied 
to the payment of any dividend, unless these fixed assets are of a 
wasting nature, such as mines. There seems also to be a consensus 
of opinion that dividends can only be paid out of the surplus profits 
derived from the use of the capital of the company for those purposes 
for which the corporation was constituted. 

The Statute Laws vary in every state, but the above principles 
seem to apply generally, with the exception of certain classes of busi¬ 
ness governed by special laws — such as banks, which may not pay 


CORPORATION PROFITS 


51 


dividends out of the interest accrued, but not received, however well 
secured, and insurance companies, which may not distribute unearned 
premiums; and in Connecticut it has been held that if at the time of 
declaration of a dividend the property is not actually worth the par 
value of the stock which was issued for it, the dividend is illegal. 

ACCOUNTING PRINCIPLES 

33. From an accounting standpoint, perhaps the only exception 
that can be taken to the law as at present interpreted is that the latter 
does not require the maintenance of wasting.fixed assets which are 
used up by slow degrees in the process of earning profits. On prac¬ 
tical if not on theoretical grounds the principle must be accepted 
that a decrease in value of fixed assets not of a wasting character 
arising otherwise than in the process of earning profits need not be 
provided for. It is true that in the long run all shrinkage of these 
assets is a loss, and that no profits can be earned over the whole life 
of a corporation unless its capital, both fixed and circulating, is main¬ 
tained intact. But the changes in actual values of capital assets 
due to lower range of prices, introduction of improved processes of 
manufacture, etc., may be so great and at the same time so indefinite, 
and the actual realization thereof is as a rule deferred to such dis¬ 
tant periods that it becomes quite impracticable to provide for it as a 
direct charge against profits; although it is a prudent course to ac¬ 
cumulate a sufficiently large Reserve or Surplus Fund, and to make 
liberal provision for Depreciation, as will insure the integrity of the 
investment and provide ample funds for keeping it continually in 
the highest state of efficiency. 

The sound accounting principles for the determination of profits 
may be summed up as follows: 

(1) All waste, both of fixed and circulating assets, incident to the pro¬ 
cess of earning profits by the conversion of circulating assets must be made 
good out of the profits earned. 

(2) Profits realized on sales of fixed assets should be first applied to make 
good estimated depreciation (if any) in other fixed assets not resulting from 
the ordinary conduct of the business. If there is no such depreciation, such 
profits may be distributed as dividends, but should be distinguished from the 
operating profits. 

(3) A sufficient surplus should be accumulated (in addition to the pro¬ 
visions required to maintain wasting capital assets under clause 1) toi the 
purpose of making good losses due to shrinkage in values ot fixed assets arising 
from causes other than the ordinary operations of the company. 


CORPORATION PROFITS 


52 


ACCOUNTING PRACTICE 

34. Turning now to the practical, as opposed to the theoretical 
view of the question, it will be useful to consider the different elements 
which enter into the determination of the profits of a corporation 
from the point of view of the maintenance of assets, discussing shortly 
the principles of valuation which should be adopted for the various 
assets and liabilities in a balance sheet, and the effect which each 
would have on the profits. If the balance sheets at the beginning 
and end of a period are theoretically and practically accurate, and 
show the true financial position at those dates, the increase or decrease 
of the surplus, after allowing for distributions of profit during the 
interval, represents the true profit or loss for the period. The different 
captions will be dealt with in the order in which they would usually be 
stated. 

CAPITAL OR FIXED ASSETS 

35. These would in general consist of one or more of the follow¬ 
ing classes: Real Estate, Buildings, Plant, Machinery, Tools, 
Patents, and last but not always least, Goodwill and Franchises. 

36. Real Estate, Buildings, Plant, Machinery, and Tools. Deal¬ 
ing with the first five items it may be stated generally that it is not 
proper for a corporation to take credit for a profit, nor on the other 
hand is it necessary for it to charge itself with a loss, arising out of a 
revaluation of such items as long as they are in actual use for the pur¬ 
poses of the business; but here it should be noted that if the business 
includes among its objects the purchase and sale of assets of this 
class they should then be considered not as Fixed, but as Current or 
Circulating Assets, being in fact stock in trade, the turning over of 
which .is expected to result in profits or losses to the company. The 
fixed assets now under consideration are those which during the life 
of the business will remain, whether in their present or some other 
shape, in a permanent condition, provided that due provision is made 
for wear and tear or other waste due to operations. 

37. Depreciation. This raises an issue of great importance, so 
far as profit is concerned, in dealing with this portion of the com¬ 
pany’s property. As distinct from fluctuations due to rise or fall in 
values, there is continually in progress in the case of all property ex¬ 
cept land, a waste due to the use of these properties for the purpose of 


CORPORATION PROFITS 


53 


earning profits. In accordance with the accounting principles already 
laid down, this waste must be provided for out of the resulting prof¬ 
its, or if there have been no profits, the losses are really so much more 
by the amount of waste resulting from the operations. 

No provision as a rule requires to be made for depreciation 
of real estate, except in the case of leaseholds, minerals, timber or 
other similar property. A purchase of leasehold property is in effect 
a payment of rent in advance, and the equivalent rent on an actuarial 
basis should be charged each year against profits. 

In the case of minerals, the product taken out of the land be¬ 
comes the stock in trade of a corporation as soon as it is extracted, 
and whatever the land was worth before its extraction it is clearly 
worth an appreciable amount less thereafter. The provision to be 
made should be on the basis of the number of tons extracted, having 
regard to the total tonnage available and to the realizable value of the 
property after the minerals have all been extracted. The same prin¬ 
ciple would also apply to timberlands, where no provision is made for 
re-foresting. The contention is sometimes made that no provision 
need be made for exhaustion of minerals where the amount of mineral 
known to be in a definite tract at the end of any period is largely in 
excess of that which has been discovered at the beginning of the 
period. This argument cannot, however, for a moment be admitted 
except as a reason for reducing the tonnage rate to be provided. As 
a general principle, whatever there was in the land, whether known 
or unknown, has been reduced during the period under consideration 
by whatever amount has been extracted; and while the new dis¬ 
coveries may be accepted as reducing the necessary rate of provision 
for extinction from (say) one dollar to one cent per ton, the original 
principle that provision must be made holds good on the smaller fig¬ 
ure, whatever it is. It may be, of course, that the provisions made in 
earlier years have been sufficient to cover a number of future years 
on the basis, from the commencement, of the rate subsequently found 
to be sufficient in view of the new discoveries, and in this case there 
is obviously no necessity to provide further for extinction until the total 
production at the new rate is equal to the total amount written off. 

It would be beyond the scope of this paper to discuss what the 
different rates of depreciation on different classes of property should 
be, but it is necessary to emphasize the fact that however long the 


54 


CORPORATION PROFITS 


life of the buildings or plant, and however much may be spent yeai 
by year in the actual upkeep thereof, there must be a gradual de¬ 
preciation in value, due either to direct wear and tear or to the neces¬ 
sity of replacing old and obsolete articles by new and up-to-date 
ones. It is probable, however, that in any going concern which is 
maintained in an efficient condition there is a limit to the total amount 
of this depreciation as between original cost and present value; in 
fact, the theory that any piece of machinery or any building continues 
in use until it reaches an absolute scrap value is not in accord with 
practical experience, taking any plant as a whole. When the plant 
is entirely new it may be considered as being worth its cost. It will 
never again attain this standard, because never again will the whole 
of it be absolutely new; on the other hand, it can never fall below a 
certain percentage of this standard without becoming so inefficient 
that it could not be operated at all. Between these limits, therefore, 
would seem to lie the total amount of depreciation to be provided 
out of earnings over a long period of years, assuming that all renewal 
expenditure tending to increase the life of the plant is charged against 
the depreciation so provided. It is submitted that perhaps the most 
satisfactory way of making such provision is in the first instance to 
estimate the life of the different assets, assuming that ordinary re¬ 
curring maintenance and renewal charges are provided out of prof¬ 
its as they occur, and to set aside each year the corresponding pro¬ 
portion of the original cost, crediting the same to a depreciation fund. 
From time to time expenditures which may be termed “extraordinary 
renewals” or “periodical renewals” will require to be made, which 
from their nature increase the original life of the plant. These 
should be charged against the fund provided. In this manner an 
equitable charge would be made against earnings each year to^ repre¬ 
sent the amount of wear and tear that has accrued during the year. 
In many cases, in place of a basis of life in years, one in tons operated 
will be found preferable, in which case the charge against profits 
would take the form of a rate per ton of production rather than a rate 
per year of life. There are other methods in force for properly pro¬ 
viding for this w^ear and tear, but there is one method which it may 
safely be stated is an entirely erroneous one, and that is to set aside 
such sums as the Directors may decide upon out of the profits of each 
year upon no definite basis whatever. A decision as to the period at 


CORPORATION PROFITS 


55 


which the necessary charge should be made against profits must be 
admitted to be largely within the discretion of the managers, for the 
reason that they have to consider not only sound principles of account¬ 
ing, but also policy; but it is not inconsistent with this proposition, 
and is certainly more scientific, to adopt a sound and conservative 
basis in the first instance and create in the books a subsidiary Sus¬ 
pense Account of the proper amount each year which would be dis¬ 
charged by appropriations macfe from time to time out of surplus 
profits. Such a course is, however, at best, a makeshift and it is 
the duty of all accountants, though they cannot compel, at least to 
urge, corporations to make adequate provision for depreciation each 
year. 

38. Patents, Goodwill and Franchises. The remaining items 
included in Capital Assets—Patents, Goodwill and Franchises, are 
very much akin to one another. Theoretically it would seem that 
if a patent be granted for a term of years the amount paid for it 
should be written off against the profits earned during those years. 
But practically it is found that by the time the original patent has 
expired the corporation may have built up a practical monopoly, 
or at any rate such a lucrative business that the original cost of the 
patent is now replaced by the admitted value of the goodwill. More¬ 
over, it is seldom the case that one patent stands by itself; during 
its life probably many others have been taken out representing modi¬ 
fications which extend the life of the original in an improved form, 
and these mav have cost small sums as compared with the very much 

t/ 

larger cost of the original. 

Goodwill represents the value of the trade name, business con¬ 
nection and organization of the corporation’s undertaking. As long 
as the earnings of the business are maintained at not less than the 
level contemplated at date of purchase, it is impossible to allege any 
depreciation of value or the necessity of any provision therefor. On 
the other hand, if any serious depreciation has taken place, the 
profits are probably so much reduced that it is not possible to make 
such provision. Goodwill is in fact a Fixed Asset whose value is to 
some extent dependent upon the profits earned, its fluctuations being 
consequent upon and not a cause of the earning of profits, as aie 
wasting or partially wasting assets, and 'not therefore to be taken 
into account in ascertaining them. 


56 


CORPORATION PROFITS 


Franchises may be either perpetual or for a fixed teim. In 
the former case, the same considerations would apply as in the case 
of goodwill. In the latter case, they may be renewed or terminated 
at the expiry of the fixed term, and prudence would dictate a reason¬ 
able provision each year out of surplus profits, although no definite 
amount may be ascertainable. 

Provided therefore that the wise policy is followed of writing 
off at once all expenditure on new patents which do not turn out 
useful, or which supersede or modify older ones, and provided also 
that the principle is admitted of building .up a substantial reserve 
fund against whatever portion of the capital is invested in this class 
of assets, it would seem reasonable to merge the three items into one 
and treat them as part of the permanent invested capital of the busi¬ 
ness, which may be left to continue at its original value as long as the 
business is a going concern. 

39. Capital Expenditure. In completing the survey of the con¬ 
ditions so far as regards Capital Assets, it is well to consider what 
expenditures may reasonably be added to the original investment of 
capital, instead of being charged against profits. These expenditures 
may be divided into the following general classes: 

(a) Actual additions to the property, such as new buildings, 
new engines or new tools, which did not exist before, or additions 
to existing articles of this class. All such expenditure would be at 
once admitted as a proper charge to Capital Account. 

( b ) Alterations to capital assets resulting in increased capacity, 
some portion but not the whole of which may in most cases be charged 
to Capital Account. 

(c) Alterations to capital assets resulting not in increased 
capacity but in a lower cost of output. Such items are frequently 
treated as additions to Capital Account, even by conservative cor¬ 
porations, but it may be doubted whether they should not rather be 
considered as operating expenses paid in advance, especially if, as in 
most manufacturing concerns, the processes to which the improve¬ 
ments are applied have only a limited life, after which they will be 
superseded by other and more modern ways of doing the same thing. 
In other words, the most conservative way of treating this class of 
expenditures would be to consider them as deferred charges to 
operating to be written off over a definite term of years against prof- 


CORPORATIOX PROFITS 


57 


its. Among this class may be mentioned change of grade or align¬ 
ment in railroads which is too frequently treated as a capital charge; 
the shifting of machinery from one position to another, or a general 
re-arrangement of a factory; as well as stripping and development 
work on mineral lands, which is of a capital nature in so far as it is 
money sunk in the property prior to taking anything out of it, but 
in all conservatively managed mines is treated in the way indicated 
above. 

( d) Alterations to capital assets resulting partly in increased 
output and partly in decreased operating expenses. In this class 
much must depend on the nature of the expenditure, but a division 
between Capital and Operating Accounts on some definite basis 
arrived at on the principles outlined in ( b) and (c) would as a rule 
be fair and conservative treatment. 

(e) Exceptional and extraordinary renewals of existing assets 
resulting partly in the increased capacity necessary in order to keep 
pace with more modern plants, partly in diminished operating ex¬ 
penses and partly in a mere replacement. Such expenditures include 
the modernizing of a property necessary to prevent or to repair a 
deterioration in its value, due either to the competition of more 
modern properties or to the greater demands of the public, and eon- 
sequentlv not resulting in increased earnings. Here again many 
corporations will charge part of such expenditures to Capital Account, 
and would be legally justified in so doing; but undoubtedly the safe 
and conservative course is to charge them wholly against profits 
through the medium of a Depreciation or Improvement Fund. 

• (j) Finally, we have ordinary replacements, repairs and re¬ 
newals recurrent either at long or short intervals, and resulting 
neither in increased capacity nor in saving in operating expenses. 
Such would always be a charge against profits, either through the 
Depreciation Fund or direct, according to the nature of the outlay. 

It is important to note that the charges made under any of the 
above headings should be cost only and should not include any 
addition by way of profit. The operation is merely a conversion of 
current into fixed assets,, upon which no profit can be realized as long 
as the asset is maintained. Possibly, however, where a corporation 
emplovs in the erection of plant for its own purposes facilities which 
it would otherwise be employing in similar erections for outsiders 


58 


CORPORATION PROFITS 

at a profit, it would be fair, although not conservative, to consider a 
reasonable charge for the use of these facilities as part of the cost of 
erection. Also when special loans are raised for construction pur¬ 
poses, the interest on such loans during the period of construction 
would fairly be part of the cost. 

40. Sale of Fixed Assets. If fixed assets, becoming unneces¬ 
sary for the purpose of the business, are sold or are abandoned and 
dismantled, the question arises whether profit or loss arising there¬ 
from should be added to or deducted from the profit arising from the 
general operations. Legally, if as a result of a revaluation of capital 
assets a surplus was found to exist, the realized portion thereof may 
probably be treated as a profit, but not otherwise; and on the other 
hand there would not appear to be any legal necessity to provide for 
a loss. As a matter of accounting, the safe policy is to carry for¬ 
ward profits and provide for losses, but the circumstances in each 
case must be considered. Where the losses are large, as in the case 
of the dismantling of a whole plant, it would be sufficient to provide 
for it gradually out of the profits of a series of years. 


CURRENT ASSETS 

41. Current assets may be dealt with under the following main 
headings: 

Stocks on hand, including Raw Materials, Work in Progress and Partly 
Finished and Finished Products. 

Bills and Accounts Receivable. 

Marketable investments. 

Cash. 


42. Stocks on Hand. Perhaps one of the most difficult ques¬ 
tions which accountants have to decide is the correct enumeration 
and valuation of stocks’on hand. The theory governing the valua¬ 
tion of this asset is that, inasmuch as no profits can be realized until 
the goods are actually sold, it is not safe to take credit for any profit 
thereon until a sale has been effected; that therefore it should be 
carried forward at the exact cost and no profit thereon brought into 
the accounts of the fiscal period. On the other hand, it may be found 
that the prices both of the raw materials and the finished product 
have at the close of the fiscal period fallen below their cost, and while 
it is impossible to say until the goods have been sold whether any 


'CORPORATION PROFITS 


59 


loss will unltimately be made thereon, at any rate there is a possibility 
thereof. It is therefore conservative to set aside a sufficient reserve 
out of profits which have been realized on goods already sold to pro¬ 
vide for the accruing loss on those which remain in hand. Hence 
the general rule for valuation of stocks on hand—namely, “cost or 
market, whichever is the lower,” has been evolved and is adopted by 
the most conservative commercial institutions. Unfortunately, in 
practice,' many concerns are unable to ascertain the cost of their 
various products, with the result that their stock valuations are based 
entirely on estimates of costs made with more or less accuracy. There 
does not appear to be any legal obligation on a corporation to adopt 
any particular basis, provided that the price adopted is not in excess 
of that ultimately realized after deduction of any subsequent cost of 
completion, storage and sale; but the absence of approximately exact 
knowledge as to the cost frequently leads to disappointment, both 
to the directors and stockholders, and even to serious financial loss. 
It is obvious that a constantly changing basis of cost must lead to 
serious inequalities in the profits shown between one period and 
another, but it is not equally obvious to the commercial community 
that an erroneous basis of valuation consistently adopted year after 
year, even if that basis be a conservative one and really below true 
cost, may result in large and unexpected discrepancies between the 
profits shown in different periods. For instance, if stocks be valued 
on a basis exceeding cost and the trade, and consequently the ma¬ 
terials and products on hand, increase very rapidly for one or more 
years, the profits during those years of increase will be abnormally 
inflated; but when the trade settles down to a comparatively steady 
turn-over there will be a considerable drop in the profits as com¬ 
pared with the preceding year on the same amount of business done 
—a drop which the management as a rule will be unable to account 
for until an investigation by the Public Accountant discloses the true 
cause. On the other hand, if the stocks be conservatively valued 
considerably below cost, the profits of a year in which a small quan¬ 
tity of goods is carried over at the close of the year in comparison with 
the beginning will be inflated as compared with a succeeding year, 
when an opposite condition prevailed, although the sales and pfofit 
thereon may have been the same in both years; thus entirely upsetting 
all the calculations and estimates of the managers. The essentials 


(30 CORPORATION PROFITS 

therefore for ascertaining correct profits so far as stocks on hand are 
concerned are: 

(a) An accurate enumeration of the quantities on hand. 

( b ) An accurate ascertainment of the actual cost of the different manu¬ 
factured articles, either completed or in progress. 

(c) A specific reduction in the prices of raw materials of the amount 
by which the market valuations at the close of the fiscal period fell short of 
the cost. 

(d) A proper provision for all stock which is old or depreciated or for 
any reason likely to be unsaleable. 

\ 

The more exactly these different elements are ascertained, the 
more accurate will be the resulting statements of profits, and if the 
special reserves be made separately, it will be an easy matter to com¬ 
pare usefully one period with another. 

Finally, it should be noted that it is not essential, and in fact 
it will frequently be incorrect, to value materials and products on 
hand at the end of the fiscal period upon the same price basis as at 
the commencement of that period; all that is necessary or proper is 
that the basis of valuation—that is to say, the principles on which 
the values are arrived at—should be the same at the beginning and 
end of the period, the actual prices usually varying from one year to 
another. 

In this connection, it is important to consider to what extent 
it is permissible to anticipate profits on work in progress, particu¬ 
larly when the work is being carried out under definite contracts, 
and when it may perhaps reasonably be contended that at any rate 
some portion of the profit is earned at the time when the work is per¬ 
formed. It is quite a frequent practice where contract work extends 
over long periods of time to estimate and bring into account some 
portion of the profit proportionate to the cost for any period, and there 
does not appear to be any objection in principle to the adoption of 
this practice. On the other hand it is undoubtedly more conserv¬ 
ative not to take credit for any such profit until the whole contract 
is completed. An added reason for this course is that unforeseen 
contingencies are continually arising during the progress of the work 
with the result that what was originally expected to realize a profit 
may in the end result in a loss. It is true that the more conservative 
course may cause large inequalities in the amount of profit shown 
for successive periods; but if the accounts are stated on a basis of 


CORPORATION PROFITS 


61 


total work completed less cost thereof, the reasons for the fluctua¬ 
tions, as well as the advantages of more rapid completion, are apparent. 

If, however, estimates of profits on pending contracts are to be 
taken into account, it is of the utmost importance that such should 
be made on an ultra-conservative basis, and further, that estimated 
losses should be fully provided for. Neglect of this precaution may 
easily lead to disaster. 

While therefore under certain conditions no objection can be 
taken to the inclusion in a profit and loss account of profits on work 
in progress, a sound conservative policy would be against such a 
practice on the ground: 


That the best estimates are misleading. 

That such profits are not in most cases yet realized amd cannot therefore 
be employed in payment of dividends except by a corresponding increase in 
working capital. 

That the asset of work in progress is unduly swelled by an addition that 
may perhaps never be realized. 


43. Accounts and Bills Receivable. Profits cannot be definitely 
ascertained until they have been converted into cash or into some 
recognized form of negotiable instrument of definite and fixed value, 
but the usual practice is to consider the profit realized when a sale 
takes place and the amount of the sale price is charged to the pur¬ 
chaser. It is essential to an exact determination of profits to ascer¬ 
tain that as far as possible the purchaser’s obligation is good for the 
face value of the charge made. This is necessarily a matter of esti¬ 
mate and involves two considerations: 


An estimate of the ability of the purchaser to pay the amount he has 
contracted to pay within the time contemplated. 

( b ) An estimate of the amount which a debt incurred in a foreign 
currency may be expected to realize in the standard oi the home countiy at 
the time when the debt is paid by the purchaser. 


On die principle of cost or market valuation, whichever is the 
lower, the conservative and safe course it to make a reserve sufficient 
to provide for all discounts that will be allowed and for any debts 
known to be of a doubtful character; or to build up a general reserve 
fund against such losses, on the basis of a percentage on the sales of 
each year. From the legal point of view, all that would seem neces¬ 
sary would be to make a fair estimate of what eacn debt might be 
expected to realize in the currency of the home country, allowing 


CORPORATION PROFITS 


62 

lor the time estimated to elapse before collection; but a corporation 
should aim at a more conservative policy than this, and should not 
be contented with the minimum amount of reserve which it might 
be legally called upon to make. 

44. Marketable Investments. The term Marketable Invest¬ 
ments is intended to include only such investments as are part of the 
Circulating as distinct from the Fixed Assets. The latter class of 
investments may be defined as those which cannot be disposed of 
without affecting the operations, for the reason that the ownership 
thereof in a permanent form is necessary, however remotely, to the 
business which the corporation is carrying on. Their valuation 
would be governed by the same principles as have been outlined 
above for other Fixed Assets. 

Marketable Investments, on the other hand, may be either: 

(a) The stock in trade of the corporation, or 

(b) The investment of surplus cash held in this form until required for 
ordinary operating purposes, or 

( c ) The investment of a reserve or other special fund. 

In case (a) the rule of cost or. market value, whichever is the 
lower, applied to each individual investment and not to the group 
as a whole is undoubtedly the most conservative. That is to say, 
no profit could be taken up on any investment until it is sold, but on 
the other hand, where the value has clearly fallen, some provision 
should be made therefor. Where, however, the investments all have 
a definitely ascertainable market value at any time, it is perhaps fair 
and reasonable to allow a fall in value of some individual invest- 
ments to be set off against a rise in value of others, provided that the 
aggregate valuation is not above original cost or market value, which¬ 
ever is the lower. 

In case (&) the usual custom is to value at the mean market 
price on the last day of the fiscal period for the reason that the in¬ 
vestments represent the equivalent of cash and should therefore be 
maintained at their cash value in the Balance Sheet. 

In case (c) any profit or loss, either realized or estimated, would 
be a credit or charge to that fund and not to the Profit and Loss 
Account. But in the Balance Sheet such investments should either 
be clearly stated as maintained at cost or preferably be adjusted 
each year to the aggregate market value if below cost. 


CORPORATION PROFITS 


63 


Another method of dealing with the fluctuations of marketable 
investments of classes (fo) and (c) is to create an investment fluctua¬ 
tion reserve, either out of estimated or realized profits on invest¬ 
ments, or by a charge to Profit and Loss of such an amount as may 
be necessary to prevent this reserve from showing a debit balance, 
and by charges or credits to this reserve to maintain the asset at 
market value. 

4/ . Cash. This item is the only one which may be said really 
to represent actual fact as expressed in money value, except when it 
consists of currency of a foreign country, at a variable rate of ex¬ 
change. This latter subject is referred to later. 

LIABILITIES 

46. Inasmuch as the liabilities of a corporation are with very 
few exceptions definitely ascertainable amounts, no question of prin¬ 
ciple arises thereon in connection with the ascertainment of profits 
or losses except that the omission of any liabilities or an overstate¬ 
ment thereof would necessarily increase or diminish the profits re¬ 
spectively. There are, however, some important questions in con¬ 
nection therewith, that is, the proper treatment of premiums and 
discounts on stocks and bonds issued, sinking funds and secret 
reserves. 

47. Premiums and Discounts on Stocks and Bonds. If stocks 
or bonds are issued for the purchase of any definite property, it may 
be presumed that the property is worth the par value thereof. But 
when they are issued for cash or a cash equivalent differing from 
their face value, important questions arise. 

So far as stocks are concerned, it is doubtful how far an issue 
thereof at a discount is legal at all, and whether if so issued the pur¬ 
chaser or holder is not liable to pay up the whole of the discount, at 
any rate on liquidation of the corporation. This is the law in Eng¬ 
land with the exception that it is now legal for a corporation to- pay 
a reasonable commission for services in placing its stock, and it is 
also the statute law of some states in this country, notably New York. 
Discount on stock would therefore either be an asset of the corpora¬ 
tion recoverable from some person or persons and not chargeable to 
profit and loss, or the liability on the stock would be the amount 
actually paid for it. Premiums on stocks issued are clearly a source 


64 


CORPORATION PROFITS 


of surplus to the corporation eventually, because they are cash re¬ 
ceived in excess of the authorized capital which must be maintained 
intact, but they are not profit on operations and should not there¬ 
fore be credited to profit and loss, although they may presumably 
be applied to make good depreciation in fixed assets or exceptional 
losses, not arising out of the ordinary business of the corporation. 

Premium and discount on bonds is a deduction from or addition 
to the rate of interest which the bond carries; that is to say, there is 
a rate at which any corporation can place its bonds at par; if it elects 
to place them at any other rate the bonds will sell at a premium or 
discount as the case may be; but the true rate remains the same and 
this true rate is the proper charge to Profit and Loss Account. Hence, 
the premium or discount should be spread over the term of the bonds 
and the annual installment thereof credited or charged to Profit and 
Loss each year. 

48. Sinking Funds for Redemption of Debt. Sinking funds 

or debt extinguishment funds are not in theory a charge against 
Profit and Loss, for the reason that they do not represent a loss or 
expense, but the extinction of an existing liability. Inasmuch, how¬ 
ever, as in most cases the only source out of which such redemption 
fund can be provided is the surplus earnings, it is usual to insert a 
provision in trust deeds that the sinking fund is to be provided out 
of the profits of the year. The discharge of liabilities involves either 
a corresponding reduction in assets or the accumulation of other 
liabilities or surplus. A reduction in current assets or the accumula¬ 
tion of other liabilities as a substitute for bonded indebtedness is 
clearly undesirable, and it is therefore necessary that the amount 
applied each year to sinking fund purposes should be transferred 
from Profit and Loss either to a special Reserve Fund or in reduction 
of some Fixed Asset account by way of provision for depreciation or 
otherwise. It must, however, be remembered that such provision 

for depreciation will be to that extent represented by capital instead 

* 

of current assets, and while there is no theoretical objection to this 
if the depreciation fund is sufficiently large, the latter necessarily 
ceases to be available in cash for one of its principal purposes, that 
is, the renewal of various capital assets from time to time. If, how¬ 
ever, part of the fixed assets are of a wasting character, the sinking 
fund may be quite safely applied in reduction thereof, or it may with 


CORPORATION PROFITS 


65 


equal propriety be applied in reduction of goodwill or patents. The 
safest way undoubtedly therefore in every case is to charge the sink¬ 
ing fund installment to Profit and Loss each year, and either credit 
it to a special Sinking Fund Reserve or apply it as depreciation of 
some fixed asset for the renewal of which no cash expenditure will 
be required in the future. 

49. Secret Reserves. There is a general consensus of opinion 
that an overstatement of profits knowingly made is improper, but 
the opposite proposition as to an understatement of profits has so 
far received little consideration, and yet is it of considerable import¬ 
ance. Corporations are the property of the stockholders, and there¬ 
fore primarily anything which the stockholders or the directors elected 
by them may approve may be considered to be within their power to 
decide as they like, provided that it is within the law; and it is not 
suggested that there is any general law which would prohibit an 
understatement of profits, as it would undoubtedly prohibit an 
overstatement. But inasmuch as the stocks of the majority of cor¬ 
porations are quoted on the Stock Exchanges throughout the coun¬ 
try, the corporation is in some sense the property also of the public. 
It becomes therefore a great question to what extent it is legitimate 
or proper that it should publish a statement of its earnings or its 
position which materially underestimates either; and yet it is ob¬ 
viously within the discretion of the managers or directors to make 
reserves to meet possible contingencies, and the constitution and 
by-laws of most corporations give them such powers. Secret re¬ 
serves may take several forms, such as writing down to a compara¬ 
tively small figure valuable assets, providing excessive depreciation, 
providing excessive reserves for bad debts, or contingencies, valuing 
stocks of materials and products on hand at a large reduction from 
cost, or including special reserves under the head of Accounts Pay¬ 
able. Inasmuch as the majority of industrial corporations do not 
publish their gross earnings, such reserves can easily be made and 
are made continually in a form in which they do not appear in any 
way in the accounts, and are known therefore only to the directors 
and managers. 

Each case must be judged on its own merits. Where the direc¬ 
tors or managers have exercised a wise discretion in providing in 
advance for contingent losses which are incident to the nature of the 


00 


C()IIP()RATION PROFITS 


business and cannot, from a reasonable point of view, be considered 
as in excess of the amounts which a wise foresight would provide, 
it would seem that no exception should be taken to the undisclosed 
provision thereof. Where, however, reserves are made largely in 
excess of any possible contingencies, the amounts provided should 
be disclosed in the Profit and Loss Account and probably also in the 
Balance Sheet, so that all those interested may be in a position to 
form a reasonably correct opinion as to the financial position. For 
instance, a business such as banking is from its nature peculiarly 
liable to large and unexpected losses, the disclosure of which might 


prejudicially affect its credit and position in the eyes of the public 
and of its depositors, and possibly cause a disaster out of all propor¬ 
tion to the cause; and it is therefore obviously sound policy to accumu¬ 
late such ample reserves as will enable losses to be met without any 
apparent disturbance of normal conditions; but so far as the majority 
of corporations and businesses are concerned, publicity in such mat¬ 
ters is undoubtedly most desirable, and all reserves to meet contin¬ 
gencies which may occur in the future, but have not yet occurred, 
should be fully disclosed. 


FLUCTUATIONS IN EXCHANGE 

50. When a corporation is carrying on business in a foreign 
eountrv the rate of exchange exercises a considerable effect on the 
valuation of its assets and consequently on its profits. This question 
is sufficient in itself to form the subject of an entire paper, and it is 
only possible here to state quite shortly the general principles which 
should govern its treatment. Where operations are carried on in a 
foreign country, the object should be to obtain as nearly as possible 
an exact equivalent in the home country of all revenue earned or 
expenditure incurred in the foreign country. So long as a transac¬ 
tion originates and is completed in the foreign country, no question 
of exchange comes into the calculation. Where, however, in the 
process of its completion it passes from one country to another, a 
change in the basis of value occurs, which must be reflected in the 
accounts. The nearest approach to accuracy will be obtained by tak¬ 
ing up the foreign item into the home currency at the rate of exchange 
of the day on which the transaction represented by that value passed • 
from one country to the other. This would result over a given period 


CORPORATION PROFITS 


07 


in a certain average rate of exchange for all transactions In the 
case of capital expenditure, it is probably wise to make that period 
as short as possible, say monthly. In the case of profit and loss 
items, it is probably sufficient to make it a year or half year. If the 
conversions at monthly intervals be used in arriving at the average 
rate of exchange for the year and the current assets and liabilities 
existing at the end of the year as well as the profit and loss items be 


converted at that average rate, all the operations in the foreign coun¬ 
try will be found to have been converted into the home currencv at 
t t true rate and there will be no difference, or as it is 

commonh called, Piofit or Loss on Exchange. Inasmuch, however* 
as this average rate may vary considerably from the actual rate on 
the last day of the fiscal year, it is further customary in preparing a 
Balance Sheet to reconvert the current assets and liabilities at the 
latter rate, and the difference between this conversion and that made 
at the average rate for the year represents an actual profit or loss 


which would be made if the whole of the assets or liabilities were 
converted into the home currency on that day. This revaluation is 
necessarv in order that the Balance Sheet may show the actual net 
realizable value of the corporation’s current assets; and the profit or 
loss thereon is invariably considered a credit or charge to the Profit 
and Loss Account for the fiscal period. Fixed capital, on the con¬ 
trary, if recorded permanently in the currency of the foreign country, 
should be maintained on the basis of original cost without any change 
from the original rate; and as this gives rise to difficulties it is pre¬ 
ferable that such assets should always be permanently recorded in the 

home currency. 

*/ 


FORM OF PROFIT AND LOSS ACCOUNT 

51. Although the question of profits has been considered from 
a Balance Sheet point of view, their presentation will always take 
the form of an Earnings Statement, each element in which will be 
accurately determined if due effect be given to the principles of valua¬ 
tions of assets and liabilities hitherto discussed. It will be useful 
now to consider shortly the form which such a statement of earnings 
should take. 

The following, already in fairly general use, is submitted as 


68 


CORPORATION PROFITS 


perhaps the most complete short form, and by means of exhibits it 
is capable of amplification to any extent desirable: 

Gross earnings (whether sales of products, transportation earnings, 

professional earnings, etc.) . $. 

Deduct —Cost of Manufacture or Operation: 

(a) Manufacture (for a manufacturing concern): 

Labor. $. 

Material. 

General Manufacturing Expenses. 

(b) Cost of operation (for concerns not manufac¬ 
turing): 

(Under suitable headings according to the 

nature of the business). 


Gross Profits. $ 

Other Earnings. 


Deduct — 

Expenses of sale (manufacturing business only). . . . $ 
Expenses of management (if distinct from opera¬ 
tion) . 


$ 


Net Profits from Operations. $ 

Deduct — 

Interest on Bonds. $. 

Other Fixed Charges. 

Surplus for the year. $ 


Extraordinary Profits (detailed). 

Surplus brought forward from preceding year. 


Deduct — 

Extraordinary charges not applicable to the opera¬ 
tions of the year. $ 

Interest and Dividends on Stocks. 


Surplus carried forward . $ 


A word of warning may not be out of place against the too common 
practice of throwing back extraordinary charges on to the previous 
year's surplus without sufficiently disclosing the same. Cases are 





















































CORPORATION PROFITS 


G9 


frequent in which the earnings for a series of years have been made 
use of in the public press to show the operating results, and therefore 
incidentally the earning capacity of a business, while charges made 
in any year against surplus, on the ground that they appertain to the 
operations of a preceding year, have been altogether ignored. The 
form suggested above, if generally adopted, would prevent the pos¬ 
sibility of any such misstatements, at any rate without a clear knowl¬ 
edge on the part of those making them that they were altogether mis¬ 
leading. 

SPECIAL POINTS IN CORPORATION ACCOUNTING 

52. Accounting problems may be divided into two groups: 

Firstly. Bookkeeping questions, being those which deal with 

the correct method of recording any given set of facts, or involve a 
correct interpretation of facts already recorded; and 

Secondly. The more difficult and important problems of ascer¬ 
taining upon a proper interpretation of legal and other documents, 
and upon sound commercial and financial principles, the actual facts 
which have to be or should have-been recorded in the books. 

In this paper it is proposed to deal briefly with some of the more 
common of the questions falling under the second of these heads, 
commencing with the consideration of some special points in connec¬ 
tion with the organization of a corporation and the opening of its 
books. 

ORGANIZATION OF A CORPORATION 

53. The facts which have to be ascertained and made the basis 
of the opening entries will be found firstly in the Articles of Incor¬ 
poration and By-Laws of the corporation which should be carefully 
studied and all provisions relating to the financial affairs of the 
business noted; and secondly, in agreements or contracts either for 
the purchase of some business concern, manufacturing or otherwise, 
or in relation to the business which the corporation intends to carry 
on; and out of the provisions of these contracts difficult accounting 
questions frequently arise. 

For the purpose of illustration it will be useful to consider in 
detail the following assumed case: 

A corporation is formed on January 1st, 1909, with an authorized 
capital of SI,000,000, for the purpose, among other things, of pur- 


70 


CORPORATION PROFITS 


chasing a manufacturing business as a going concern. The con" 
tract between the corporation and its promoters, dated January 1st, 
1909, provides that the business to be purchased shall be taken over 
as from July 1st, 1908, and that interest on the purchase money of 
$900,000 shall be paid to the vendors in lieu of the profits which may 
have been earned from July 1st up to the date of completion of the 
purchase. The Statement submitted to the purchasers as of July 
1st, 1908, and accepted by them as the basis of the contract, shows the 
following figures extracted from the books: 


CAPITAL ASSETS 


Land. $ 30,000 

Buildings. 90,000 

Fixed Plant and Machinery. 180,000 

Loose Tools. 25,000 


CURRENT ASSETS 
Inventories of Manufactured Products, 


Stores and Material, on hand. $125,000 

Accounts Receivable. 90,000 

Cash. 10,000 


$325,000 


Less: 


$225,000 

CURRENT LIABILITIES 


For Accounts Payable 


25,000 


200,000 

Net Total Assets after deducting Liabilities. . . . $525,000 

The books also show that the profits for the three years ending 
July 1st, 1908, have averaged $75,000 per annum, and after the pur¬ 
chase has been completed under the contract, it is ascertained that 
the profits from July 1st, 1908,'to January 1st, 1909, have, according 
to the books kept by the vendors, amounted to $50,000, and that dur¬ 
ing those six months a sum of $20,000 was distributed among the 
partners or stockholders of the vendor concern. 

The net tangible assets to be acquired amounting to $525,000, 
and the purchase money to $900,000, the difference, namely, $375,000, 
might at first sight be taken to represent the cost of the goodwill 
of the business purchased, being the equivalent, it will be seen, of 
five years’ purchase of the average profits, and it is quite probable 
that this was the actual basis of the contract. 















CORPORATION PROFITS 


71 


It is no exaggeration to say that in the majority of cases the 
books of the new corporation would have been opened as of July 1st, 
1908, on the basis of that Statement, and the profits earned during 
the next six months, after deduction of the interest, amounting to 
$22,500, payable to the vendors under the contract, would be treated 
as its profits. A little consideration will, however, show that this is 
not a correct basis of facts for opening the books of the new com¬ 
pany. To begin with, the company did not come into existence 
until January 1st, 1909, and as it obviously could not acquire property 
before it existed, it is clear that what it has really purchased is the 
property not as it was at July 1st, 1908, but as it was at the date of the 
contract to purchase, which happens also to be that of the formation 
of the company, viz., January 1st, 1909. Moreover, the contract 
specifically provides for the inclusion in the purchase of the profits 
earned (less the interest payable) for the preceding six months; and 
as the profits so earned, less the sum of $20,000 distributed, have 
remained in the business, the surplus assets will have increased by 
$30,000 during that period; or rather by $27,500, since the interest 
due to vendors up to January 1st, 1909, exceeds the profits withdrawn 
by $2,500, which is, therefore, a Liability on that date, and must be 
taken into account. This increase may be represented either by 
additional construction expenditure made during that period, or bv 
increased current assets, or by both, and there will probably also be 
a variation in the current liabilities; but the new corporation is cer¬ 
tainly getting in property of one kind or another $27,500 moie than 
it would have got if the contract had not provided for the acquisition 
by it of the profits accrued during the six months. It must be as¬ 
sumed, therefore, that the purchase price of $900,000 is greater by 
this amount than it would have been it the accrued profits, which are 
turned over to the corporation when it obtains possession of the prop¬ 
erty, had not been acquired; or, in other words, that the price actually 
paid for the goodwill is not $375,000, but $347,500. 

The importance should here be noted of the three following dates; 

(a) The date of the contract; 

(b) The date as at which the property was to be acquired; and 

(c) The date of the formation of the corporation. 

If, for instance, the company had been incorporated on July 
1st, 1908, and a contract had been made on the same date and on the 


72 


CORPORATION PROFITS 


basis of the Balance Sheet of July 1st, but the business was not 
actually taken over until January 1st, 1909, then clearly, after July 
1st, 1908, the business would have been carried on for the benefit of 
the corporation, and the accruing profits, less interest, amounting 
to $22,500, would be profits of the corporation. But under the con¬ 
ditions assumed to exist, it would seem evident that a corporation 
cannot earn profits when it is not in existence and that therefore if 
it in any way acquires profits which were earned before the date of 
its formation, it must in some way have purchased them, as the alter¬ 
native supposition of a free gift hardly merits consideration. 

And yet there is considerable contention at the present time 
over this apparently simple point. Even where a corporation has 
contracted to purchase property at an agreed price, and the vendors 
have further undertaken to provide a certain sum in cash for work¬ 
ing capital, some lawyers have maintained that this sum is a profit 
to the corporation, and can be used for the payment of dividends. 
But vendors are men of business, and it is not their practice to give 
something for nothing. A contract must be assumed to be the result 
of a bargain between purchaser and seller, and whatever the pur¬ 
chaser is to receive under the contract must be set off exactly against 
what the vendor is to receive; and although in the formation of a 
large number of modern corporations, the vendors and purchasers, 
through the intervention of syndicates, are one and the same, the 
only safe and sound method of accounting is to assume that the same 
principles apply as in the case of an ordinary sale. It is difficult 
to believe that, if such a contract formed the subject of legal proceed¬ 
ings, any other view could be taken that the so-called gift for work¬ 
ing capital were merely a return to the purchaser of a portion of his 
purchase money, and should be so treated in the accounts. If the 
reverse principle were upheld, the sum of $27,500 in our hypothetical 
case could be treated as a clear profit to the corporation and dis¬ 
tributed in dividends, whereby, it would seem, a portion of the sub¬ 
scribed capital would be returned to the stockholders. 

Having disposed of this important preliminary point, it is now 
clear that the figures of assets and liabilities at July 1st, 1908, are not 
a proper basis for opening the books of the new corporation, and 
that a fresh Balance Sheet as at January 1st, 1909, must be prepared. 
On being advised to this effect, the officers decide on Februarv 28th 


CORPORATION PROFITS 


73 


to have a revaluation made of all the companies’ assets, having reason 
to doubt the accuracy of this July Statement. It may be remarked 
that the accuracy of this Statement had surely been substantiated 
on behalf of the corporation before the contract for purchase had 
been entered into. But it is a matter for surprise that such con¬ 
tracts involving large sums are still frequently made in sole reliance 
on statements of financial position furnished by the vendors, who, 
without any intent to deceive, will naturally make the best showing 
they can, and may be and frequently are deceived by errors of prin¬ 
ciple made by their own subordinates. The insistance on the part 
of the purchasers of an impartial investigation of all such statements 
by Public Accountants before the contracts are completed, would 
certainly save large sums of money to future stockholders. 

In our case it is assumed that no investigation was made, and 
fortunately for the stockholders the results of the revaluation prove 
that they have secured a better bargain than they thought; as the 
following statement as at February 28th, 1909, shows: 


CAPITAL ASSETS 

Land. $ 50,000 

Buildings, etc. 100,000 

Fixed Plant and Machinery.. 200,000 

Loose Tools. 30,000 

- $380,000 

CURRENT ASSETS 

Inventories and Manufactured Products, 

Stores and Material, on hand. $120,000 

Accounts Receivable. 100,000 

Cash. 27,500 

Less: $247,500 


CURRENT LIABILITIES 

For Accounts Payable. $20,000 

For Interest to Vendors 2,500 

22,500 

225,000 

Total Net Assets. $605,000 

0 

At January 1, 1909, the net total valuation might have been 
expected to amount to $552,500, being the valuation of July 1st, 1908, 
with the addition of $27,500 undivided profits. At February 28th 
it actually exceeds this figure by $52,500. This excess is found, by 

















74 


CORPORATION PROFITS 


comparison with previous statements, to be made up as regards 
$50,000 of increase in capital assets over and above the actual ex¬ 
penditures made, and as regards $2,500 of the profit for the two months 
of January and February, 1909. 

This profit is, however, so much less than that in previous 
periods as to call for further investigation, and the fact is then dis¬ 
closed that liabilities for expenses, etc., to the amount of $3,000, 
chargeable against the period previous to January 1st, 1909, had not 
been provided for at that date, but have been charged against the 
subsequent period, and also that, while the manufactured products 
on hand at February 28th had been properly valued at cost, those 
on hand at Januarv 1st had been taken at the market value, which 
was $10,000 in excess of cost. Correcting these errors, the trading 
profits for the two months are ascertained to be $15,500. 

The Directors of the new corporation, however, claim that 
they are also entitled to treat as profit the increase in the value placed 
on the capital assets, on the ground that if they were willing to pur¬ 
chase on the basis of the July, 1908, Statement for $900,000 they 
have made a profit by acquiring assets to the value of $50,000 more 
than they expected. But it must be remembered that an expression 
of values in figures is at best an estimate, more or less accurate, while 
the price paid is an actual tangible fact; and the principle previously 
stated applies here also, that whatever property is acquired under 
the contract must be held to be the exact equivalent of the price paid. 
If it eventually appears that there is more or less value than was 
supposed, so much the better or worse for the purchaser, but the 
fact remains that he paid a certain price for a certain property. If 
the tangible assets acquired turn out to be of greater or less value, 
the cost of the intangible asset of goodwill must be less or greater 
by an equal amount. Hence, in the present case, the overvaluation 
of $10,000 in the Inventory, and the understatement of liabilities 
by $3,000 on the one hand, and the undervaluation of $50,000 in 
capital assets on the other, represent a net reduction of $37,000 in 
the amount paid for goodwill, which is thus found to amount to 
$310,500. Finally, as a result of these various adjustments the 
financial position at January 1st, 1909, is ascertained to be as follows, 
and upon this basis the books of the new corporation should be 
opened: 


CORPORATION PROFITS 


75 


CAPITAL ASSETS 


Land. 

Buildings. 

Fixed Plants and Machinery 
Loose Tools. 


CURRENT ASSETS 

Inventories of Manufactured Products, Stores 

and Material, on hand. ; . 

Accounts Receivable. 

Cash. 


Less : 


CURRENT LIABILITIES 


$ 50,000 
100,000 
200,000 
30,000 

- $380,000 


$ 112,000 

95,000 

28,00 0 

$235,000 


For Accounts Payable.$23,500 

For Interest to Vendors. 2,500 

26,000 

209,000 

Total Net Tangible Assets.$589,500 

Leaving to represent Goodwill.310,000 

$900,000 


The overvaluation of inventories found to exist above is a fre¬ 
quent occurrence on the sale or transfer of a business. In selling 
stocks of material and partly and wholly manufactured products on 
hand, the vendor is clearly entitled, in default of any provision to the 
contrary, to claim the full market price. On the other hand the 
purchaser, if he pays the full market price, runs the risk of making 
no profits, or even of making a loss, on the realization of these prod¬ 
ucts. Hence, it is usual for the contract to contain a provision 
that the goods on hand shall be valued at cost. In the case under 
consideration the whole undertaking was of course purchased for 
a lump sum, but although in the Balance Sheet on which the con¬ 
tract was based market values were used, still in opening the books 
cost is the correct basis, and the adjustment made is the only fair 
way of dealing with the matter. 

Accounts receivable should be, and usually are, guaranteed 
by the vendors to the full amount; but if not, a loss may be incurred 
on the realization thereof, and this again would mean that the cor¬ 
poration has acquired less in the way of book debts and paid more 
for goodwill than it originally anticipated. Similarly, where, as in 
the illustration, liabilities are found to have existed at the date of 
purchase in addition to those included in the Statement furnished 




















76 


CORPORATION PROFITS 


to the purchasers, the excess, if not recoverable from the vendors, 
will mean a further addition to the price paid for goodwill. 

In our assumed case it will be noted that the corporation was 
easily able to adjust the accounts to a proper basis, as the books 
were well kept and the inventory valuations at previous dates were 
available. Unfortunately in practice this state of affairs is the ex¬ 
ception rather than the rule, and it is consequently often a matter of 
great difficulty to arrive at any basis for a proper adjustment, even 
when it is obvious that the books do not disclose the real facts. It 
is in such cases that the experience of the Public Accountant stands 
him in good stead, and a knowledge of where to look, and of the 
elements involved, enables him to arrive at a substantially correct 
solution. 

INVENTORY VALUATIONS 

54. An error in an inventory valuation has been incidentally 
noted in the assumed purchase dealt with above and it will be use¬ 
ful now to consider in more detail the important accounting prin¬ 
ciples involved in the accurate determination of such valuations. 

Profits can only be made out of the sale or exchange of one 
commodity for another of a definite and realizable cash value. The 
mere increase in the market value of an article, which it is not in¬ 
tended to sell at that time, cannot be considered as a profit; for the 
reason that the article may never be sold at that price, and the paper 
profit may never be realized. The object of the Profit and Loss 
Account of a manufacturing or trading concern is to ascertain as 
closely as possible the profits which have been realized on sales 
actually made; and for this reason raw materials on hand, and prod¬ 
ucts partly or wholly manufactured, but not sold, should be en¬ 
tirely eliminated. In practice this result is obtained by valuing them 
at cost, no more and no less, and so exactly offsetting the charges to 
profit and loss for materials, labor and expenses, in so far as the 
result of their combination in manufacturing processes is still un¬ 
completed and unsold. 

On the other hand, a Balance Sheet is required to show the 
true financial position as a going concern. The inventory at actual 
cost may represent more or less than the market value, and, there¬ 
fore, overstate or understate the assets; but to change the valuation 
would be to take up a profit or provide for a loss which might never 


CORPORATIC)X PROFITS 


77 


be realized owing to subsequent changes in the market value. Sound 
commercial principles require that no credit be taken for profits 
until they are realized; and further, that if there is any possibility 
that what remains unsold may not realize its cost, a proportion of 
the realized profits on sales which have been made should be carried 
forward to cover these possible losses. It is accordingly generally 
recognized as a correct accounting principle, that if the cost value of 
the inventory exceeds the market value, a reserve should be created 
to bring it down to that value, while, on the other hand, if the market 
valuation exceeds the cost, no credit should be taken for the profits 
until they are realized by an actual sale. This rule is of considerable 
importance where the inventories at the end of successive years show 
a progressive increase. If they be valued above cost, profits are 
shown in each year, which are an anticipation of those of succeed¬ 
ing years; and a large fictitious asset is created, which, on a sub¬ 
sequent fall in market values, may prove entirely valueless. In a 
quite recent case the Directors of a corporation have been held per¬ 
sonally liable for a sum of SI,000,000 in respect of dividends dis¬ 
tributed to stockholders out of fictitious profits created in just this 
way. 

The importance of a valuation at cost emphasizes the necessity 
of such a system of accounting as will enable cost to be accurately 
ascertained. The theory of cost accounting is merely an elabora¬ 
tion of ordinary bookkeeping, and its difficulty lies almost entirely 
in a correct ascertainment of the elements that enter into it. There 
is no theoretical difficulty in keeping a record of the number of 
hours, human and machine, and the quantity of material that enter 
into any process of manufacture; but practical difficulties arise from 
the large number of operations, the chances of error in the tabulation 
of hours worked and quantities consumed, loss of weight in process 
and many other minor points, coupled with the necessity of an eco¬ 
nomical operation of the cost accounting system. 

When the actual quantities of material and number of hours 
worked in the direct process of manufacture are known, there are 
innumerable other expenses which cannot be allocated to any par¬ 
ticular operation and yet are essential to all operations,-such as Steam 
Power, Light, Heat, Taxes, Insurance, General Supervision and 
Cost Accounting; and the determination of the proportion in which 


CORPORATION PROFITS 


78 

these expenses should be distributed to the different processes is a 
problem which is incapable of an absolutely accurate solution. Al¬ 
most every business differs in this respect, and various methods are 
adopted for arriving at an approximation to the result. The essentials 
are that the total amount absorbed in the cost over any period should 
not materiallv exceed, nor fall short of, the total of all such expenses 
incurred during that period; and that the method of distribution, 
once settled, should be consistently maintained regardless of the effect 
on the operations, unless and until a more accurate method can be 
substituted therefor. 

A further difficulty lies in the fact that is it not always possible 
to draw a hard and fast dividing line between expenses directly 
chargeable to manufacture and expenses not so chargeable. There 
are expenses of Supervision, Bookkeeping and General Manage¬ 
ment, which cannot be specifically divided between the different 
departments of manufacture, sale, and collection, and the general 
management of the corporate organization. The expense of the 
first department only would enter into the cost of manufacture, 
while that of the second and third would be chargeable only against 
the gross profits resulting from the sales, and that of the fourth would 
be chargeable against the profits of the whole undertaking. A 
thorough understanding of the business, a careful analysis and 
apportionment of the studies of individuals, and a general knowledge 
of the manner in which each item of expense affects the different de¬ 
partments is necessary to arrive at even an approximate division, 
and at best the basis adopted is somewhat arbitrary. 

The question continually arises whether interest in any form 
should be considered as part of the cost of manufacture. It is true 
that manufacture takes time and involves the lock-up of money for 
certain periods, and that this money should for those periods be earn¬ 
ing interest. On the other hand, it must be remembered that in¬ 
terest is only one form of profit, that the object of any business is to 
earn profit, and that each operation, as well as each department, is 
only one in a series, none of which is complete in itself, and the 
whole of which are necessary to the complete process of manufacture 
and sale out of which alone can any profit be earned. To charge 
interest into costs is in effect to add to those costs a certain amount 
of profit before it has been made, and is, therefore, against sound 


CORPORATION PROFITS 


79 


commercial and accounting principles. It is sometimes claimed 
that as interest on loan capital, from the point of view of the owner 


or stockholder is an expense, it therefore should be treated as part 
of the cost of manufacture; but such a contention entirely loses sight 
of the fact that such capital is raised for the purpose of conducting 
the business, and is remunerated by a strictly defined share of the 
profits earned in that business. It is true that interest is usually 
payable, whether there are profits earned or not, but it must ulti¬ 
mately be met out of profits, and it is merely one of the incidental 
conditions of the loan that the lender is to be paid his share of profits 
at regular dates, and frequently in advance of ! any such profits being 
earned. 

Here it may be well to point out a distinction which should 
be more widely recognized than it is between the profits of an under¬ 
taking and the profits of a particular section of those who contribute 
the capital required, as for instance the stockholders of a corporation. 
The profit of an undertaking is the difference between the sale price 
and the cost of its products after deducting therefrom the expense of 
disposing of the same. The manner in which the capital is raised 
affects not the profit, but merely the distribution thereof between 
the different interests by which the capital is contributed; and in¬ 
terest on borrowed capital is as much a part of the profit of the under¬ 
taking as is dividend on capital stock of a corporation, or the profits 
which accrue to an individual owner. 

The accuracy of the periodical Statements of Earnings of manu¬ 
facturing concerns depends to a large extent upon that of the inven¬ 
tory, both as to quantity and value. Without correct information 
as to the value of the stocks, it is impossible to ascertain the earn¬ 


ings; and yet the delay and expense involved prohibit the frequent 
taking of physical inventories, which in most cases would necessitate 
the closing of the works for a period sometimes of weeks, and a con¬ 
sequent loss of business. Up to comparatively recent times, it was 
the* practice to take such inventories once a year, closing the works 
at a suitable date for that purpose; but the demand, on the part of 
directors and stockholders, for more frequent Statements of Earn¬ 
ings has necessitated some method of arriving at the approximate 
value of stocks on hand without the expense and delay involved in a 
physical enumeration thereof, I he skill of Accountants has by 


; > ) 


80 


CORPORATION PROFITS 


degrees evolved a system of book records, continuous throughout 
the year, of materials, work in process, and manufactured products, 
which enables a book inventory to be obtained each month so accu¬ 
rately that the closing down of large works for this purpose is now, 
unless in exceptional circumstances, almost unknown. 

These book records consist of accounts, both of quantity and 
value, kept for each class of material and manufactured product, 
based on accurate returns of the quantities received and consumed, 
and of the time expended, and balancing with the principal books, 
so far as money values are concerned. The quantity and values of 
materials received are obtained from the original bills, analyzed, 
and charged to the respective store accounts. The consumption 
records are obtained from a very large number of small individual 
records of time and material expended in the various productive 
operations; these are collected, classified and summarized, and are 
charged and credited to the production and material accounts re¬ 
spectively on ordinary bookkeeping principles; with the result that 
the balance left on any material account represents the stock on hand, 
and the balance on any production account, after crediting the fin¬ 
ished product, represents the cost of the uncompleted work. 

It might be supposed that the consumption reports made up 
by working men, often illiterate, and with no idea of the purpose 
for which the records are required, would be so inaccurate as to be 
useless for practical purposes, but a little consideration will show 
that, apart from any deliberate attempt at falsification, errors would 
tend to offset each other, and the resulting difference should be com¬ 
paratively small in proportion to the totals involved. In fact, as in 
so many other problems of every-day life, the principle of averages 
obtains, and if ordinary precautions are adopted the final results 
are as a rule found to be surprisingly accurate. 

As any particular material in stock is reduced to a low point, 
a physical inventory thereof is easily taken, compared with the book 
records, and any discrepancies adjusted; and in this way almost the 
whole of the material accounts are verified physically at least once 
in the course of each year without any interruption of the ordinary 
business. In the case of large bulk stocks, such as ore, pig-iron, 
etc., the problem is a more difficult one, because it may be, and fre¬ 
quently is, a period of some years before the piles in which these 


CORPORATION PROFITS 


81 


articles are kept are reduced to a sufficiently small quantity to enable 
any accurate inventory to be taken. In these cases, however, it is 
usual to allow a small extra percentage on the consumption to cover 
waste or loss, with the result that in practice the physical test more 
often shows an excess over the book record than otherwise. 

Material in process of manufacture can usually only be physically 
verified when the process is entirely completed, which may be after 
w r eeks, months or, in large contracts, even years. But by a sub¬ 
division of accounts into different processes and small units, the 
book records are being continually verified at each end, that is, by 
the labor and material which is known to have gone in and by the 
finished product which is known to have come out, and provided 
that the values at which the material is charged in, and the finished 
product credited out, are approximately in accordance with the facts, 
the resulting balance of work still in progress must be substantially 
correct also. 

In all these accounts the month is the unit of time most usually 
adopted, and the value at which a month’s consumption of material 
should be charged out is of some importance. The safest rule is to 
assume that the stocks on hand at the beginning of the month are 
first exhausted, and to value the stock at the close at the average 
cost of the month, except where such stock is greater than the total 
receipts for the month, in which case the excess should be taken at 
the price at which the commencing stock was valued. Having thus 
obtained the value of the inventory at the close of the month, the 
consumption for the month should be credited to the material ac¬ 
count, and charged to the proper cost accounts, at a figure which 
will leave a balance on the material account equal to such inventory 
value. But this rule requires to be followed with care, because it 
might happen, for exceptional reasons, that the cost lor that month 
was either very much above or very much below the average, and 
in such a case the stocks should be adjusted to a more normal valua¬ 
tion. 

The system here roughly outlined has not only obviated the 
loss and expense involved in taking a complete physical inventory 
once a year, but has also enabled book records to be maintained of 
sufficient accuracy to justify the declaration of dividends out of prof¬ 
its ascertained therefrom. 


82 


CORPORATION PROFITS 


CONSTRUCTION EXPENDITURE 

55. In the assumed case already dealt with it appeared inci¬ 
dentally that the purchased business had, between the date of the 
contract and the date of transfer to the new corporation, converted 
a certain portion of its current into capital assets. Some general 
rules have been laid down as to different classes of expenditures, 
which might be legitimately considered as an addition to capital 
assets, and it is now proposed to consider the equally important 
point of the method of ascertaining the amount of such expenditures 
when the work is carried out by the corporation itself. 

The problems involved in the determination of the proper 
charges to be made for construction work are: 

Firstly , To correctly ascertain the actual labor and material 
expended thereon, which, if proper records be kept, is a comparatively 
easy matter, and 

Secondly, To determine the amount, if any, which shoidd be 
added to these direct costs for general and management expenses, 
and possibly for interest. 

In a going concern a conservative course is generally adopted, 
and no charge is made beyond the labor and material cost, for ex¬ 
penditures of moderate amount on additions to the property; but, 
on the other hand, if a new and distinct plant were in course of con¬ 
struction, and producing no earnings from operation, the whole of 
the administration expenses and the interest paid on loans raised 
for this special purpose, would be charged to construction account, 
and rightly so, being necessary elements of completing the work. 
This at once suggests the argument that what is reasonable and 
proper in the latter case should also be reasonable and proper in the 
former, particularly if facilities are employed which would otherwise 
be used on profitable work for outside parties. It must, however, 
be remembered that profits can only be made out of the sale of prod¬ 
ucts; and that it is, therefore, incorrect that a concern should take 
credit for profits on work which is not intended for sale, and will, 
in all probability, never be sold as long as the concern is continuing 
to carry on business. 

It would follow then that no charges should be made to con¬ 
struction for expenses which would have been equally incurred if 
there had been no such construction, and would in that case have 


CORPORATION PROFITS 


83 


been charged against profits; although if special loans have been 
raised to provide funds for construction purposes, and a special staff 
of employees maintained for this sole purpose, it would seem quite 
legitimate that the interest paid on such loans, and the salaries of 
the special staff, should be charged to Construction Account until 
the work under construction is in full operation. Any further method 
might result in the creation of paper or fictitious profits, which would 
not be realized as long as the property was operated, and might never 
be realized on an ultimate sale thereof. A good instance is the case 
of a railroad building large extensions, the material for which in 
considerable quantities is carried over its own road. The freight 
on this material forms part of the earnings of the road, and if the 
new construction bears a large proportion to the mileage in operation, 
the earnings will be swelled to abnormal proportions by the addi¬ 
tional traffic so created, and the road will appear, for a short period, 
to be earning profits entirely out of proportion to those derived from 
its normal operations. The whole of this increase is really fictitious 
and does not add to the value of the stock in any way. 

Managers of the operating departments of a factory frequently 
claim that they should be allowed to charge a profit on construction 
work carried out for their own mills, on the ground that if the work 
were done outside they would have to pay a profit, and at the same 
time would set free their own facilities to carry out additional work 
at a profit for outside customers; and they even go so far as to say 
that if they cannot charge a profit on construction work so carried 
out, they will in future have the work done on outside contracts. 
It must be admitted that this is a plausible argument, but a little 
further consideration will show that it is fallacious. There is here 
a confusion between a Profit and a Saving. The reason that a con¬ 
cern undertakes its own construction work in place of letting outside 
contracts therefor, is that it can by that means effect a saving in its 
expenditure, by taking advantage of its own capital and facilities 
to carry out the work instead of using the organization and the capi¬ 
tal of others, upon which it would have to pay a profit. The saving 
so effected is of considerable advantage in that it reduces the amount 
of capital invested and future earnings will represent a larger return 
on the investment. Moreover, it is seldom true that the use of a 
corporation’s own facilities for construction expenditure really 


CORPORATION PROFITS 


84 

means the throwing away of profitable work for outsiders, which 
would otherwise have been undertaken. It is doubtful if any well 
managed concern ever refuses profitable orders, because of its own 
construction work; its organization can and will, almost automat¬ 
ically, expand sufficiently to provide for any increase in its opera¬ 
tions which is likely to be thrown upon it. Moreover, if a sum be 
added to the cost of construction and credited to Profit and Loss, 
to represent the profit which would have been earned by the com¬ 
pany if the work had been done for outsiders instead of for itself, this 
profit can only be made available for distribution by increasing the 
amount of capital contributed for new construction work; and it can 
hardly be considered good financial policy to increase indebtedness 
for the purpose of paying dividends. The only sound principle that 
can be adopted is to charge to construction all costs and expenses 
which are directly attributable to that construction, but nothing for 
indirect expenses, interest, or profit. 

CONSOLIDATED BALANCE SHEETS AND 
EARNING ACCOUNTS 

56. It frequently happens that a corporation in place of pur¬ 
chasing the properties outright as in the assumed case, purchases 
only the stocks of one or more existing corporations, leaving the 
properties themselves vested in these corporations. 

This growing tendency to form large aggregations of capital 
on the basis of a control by one corporation of the whole or the major¬ 
ity of the stocks of a number of others has led to important develop¬ 
ments in accountancy practice. It has generally been considered 
that the Balance Sheet of any corporation, prepared from books and 
records properly kept, would disclose its true financial position, but 
the development of this system of control has shown that such a 
Balance Sheet will no longer suffice for this purpose; and it is import¬ 
ant now to realize the difference between an investment in a com- 
pany representing only a small proportion of its capital stock, and 
an investment representing the whole or practically the whole, and 
carrying with it the absolute control of the operations. Thus cor¬ 
poration “A” may own the whole stock of corporation “B,” both 
carrying on a similar business. Stockholders in “A” may know this 
fact, but have no means of ascertaining the real position of corpora- 


CORPORATION PROFITS 


85 


tion “B.” “A” having the control of “B” may turn over to “B” all 

its unremunerative work, with the result of showing large profits on 
its own accounts, while the accounts of “B” show correspondingly 
large losses. Corporation “A” in its Balance Sheet carries its in¬ 
vestments as cost, probably merged under the general head of “Cost 
of Properties,” with all its other capital assets. Corporation “B” 
may obtain loans from corporation “A,” which largely exceed its 
current assets, and may be expended in construction work, or even 
lost in operations, while corporation “A” carries in its Balance Sheet 
these same loans as current assets recoverable on demand. It is 
only necessary to point out that many of the railroad receiverships 
twelve years ago arose out of a state of affairs very similar to that 
described, to show that this is not an imaginary condition. 

Realizing the misleading character of the ordinary Balance Sheet 
in such cases, the Public Accountant has evolved the Consolidated 
Balance Sheet; the basis of which is the recognition of the common- 
sense fact that a network of companies connected with each other by 
control of stockholdings, is still in effect one undertaking, and that 
if the* stockholders in the holding company are to have before them 
a clear statement of its position, legal technicalities must be brushed 
to one side, and the position of the holding company shown in its 
relation, not to these sub-companies, but to the general public. To 
give a pictorial illustration of this position, imagine a large cube 
containing a number of smaller ones; no change in size or position 
of the smaller cubes which arises inside the larger one, can in any 
way affect the latter, in which no change can take place except by 
the entry of something from outside, or the abstraction of something 
from inside. Thus the whole position can only be changed by out¬ 
side influences and not by any relative changes of its component, 
parts. The Consolidated Balance Sheet represents the true posi¬ 
tion of the whole group of cubes to the outside world, and is thus 
not the Balance Sheet of a corporation, but of a condition after 
eliminating all the relations of the cubes one to another. Debts due 
by one company of the group to another; stocks of one company 
owned by another; earnings of one company at the expense of an¬ 
other, are all eliminated. The amount by which the value of the 
stocks of any company on the books of another exceeds or falls short 
of the par value thereof, represents an addition to or diminution of 



86 


CORPORATION PROFITS 


the asset of goodwill in the final Balance Sheet; and as a result the 
capital assets in the Consolidated Balance Sheet consist of the total 
physical assets of all the companies (that is, land, buildings, plant, 
machinery, etc.), and in addition an item of goodwill represented by 

(a) the goodwill asset in the Balance Sheets of the subsidiary com¬ 
panies, and 

(b) the amount by which the aggregate book value to the holding 
company of the stocks of the subsidiary companies exceeds the par value of 
that stock. 

Similarly, the capital liabilities represent the stocks and bonds 
of all the companies in the hands of the public, those owned between 
companies being eliminated. 

The Consolidated Earnings Account should be made up on 
the same principles. Profits resulting to one company out of sales 
to another should be eliminated. Only sales and purchases to and 
from the outside public should be included, so that no profits are 
considered such except those made on deliveries outside the organiza¬ 
tion. 

In other words, the whole organization is considered as merely 
a series of separate works under the same ownership, and the same 
accounting principles which would apply to a corporation owning 
one small factory, are applied to the large corporation owning the 
whole stocks of a number of subsidiary companies, which in turn 
own the stocks of other subsidiary companies, all the companies in 
the group themselves owning and operating their own factories. It 
will readily be supposed that in practice the preparation of a State¬ 
ment of Earnings exactly on the basis here laid down is a difficult 
matter, and probably in all its elements has never yet been attempted; 
but inasmuch as a neglect of these principles, so far as the Profit 
and Loss Account is concerned, only means the swelling of the totals 
both of gross earnings and cost of operation, it is not of so much 
importance, provided that the valuation of the stocks of goods on 
hand is made on the basis of actual labor, material and expense 
involved therein, without any proportion of the profit of the different 
companies in the organization through which these products may 
have come. 

A Balance Sheet of a corporation, whose only or principal 
assets are stated to be investments in other companies, should be 
looked upon with suspicion, unless the names of the other companies 


CORPORATION PROFITS 


87 


are given, and clear statements are also given of their financial 
position; and even then a collection of Balance Sheets cannot show 
the true financial position of the whole group until they are all com¬ 
bined into one and the inter-company interests eliminated. 

















































































- • 




V 

















* 





EXAMINATION PAPER 









































































































& a i tf* 










ACCOUNTING FOR MODERN 
CORPORATIONS 


Read Carefully: Place your name and full address at the head of the 
paper. Any cheap, light paper like the sample previously sent you may be 
used. Do not crowd your work, but arrange it neatly and legibly. Do not 
copy the answers from the Instruction Paper; use your own words, so that we 
may be sure that you understand the subject. 


1. What is meant by a pool? Name some of the weak points 
of pools. 

2. What is the nature of a trust? In what way does it differ 
from a pool? 

3. What is the nature and object of a holding company? 

4. Name some of the principal advantages of a combination 
of manufacturing enterprises. 

5. What are the most apparent evils of monopoly? 

6. How should advances to a subsidiary company be treated 
on the books of a holding company? 

7. What is a consolidated balance sheet intended to show? 
How should the accounts be grouped in this balance sheet? 

3. What is represented by property account in the consolidated 
balance sheet? 

9. When a subsidiary company is taken over by a holding 
company, how is the surplus of the subsidiary company treated on 
the books of the holding company? on the books of the subsidiary 
company? 

10. At the close of a fiscal period, the inventories of a sub¬ 
sidiary company contain merchandise, transferred from another 
subsidiary company at a price above the cost to manufacture. How 
should such inventories be considered in making the balance sheet 
of the holding company? If included at the prices shown on the books 
of the subsidiary company, how should the apparent profit be treated? 

11. Under what conditions can a corporation, whose assets do 
not equal its capitalization, be said to be not overcapitalized? 




ACCOUNTING FOR MODERN CORPORATIONS 


12. If an improvement is made in a plant which reduces the 
cost of manufacture or improves the product, displacing an older 
appliance or process, should the cost be considered as a capital or 
operating expenditure? 

13. A corporation makes an advance payment of insurance 
premiums. In making up a balance sheet, how should this advance 
payment, or that part of it represented by the unearned premium, 
be treated? 

14. What is the logical method of treating discounts on bonds? 

15. What is the nature of a sinking fund provided for the re¬ 
demption of bonds? If the property against which the bonds are 
issued does not decrease in value, what becomes of the sinking fund 
when the bonds are retired? if the property has depreciated in value? 

16. Define depreciation. On what basis should the charge for 
depreciation of a machine be calculated? 

17. What does a consolidated profit and loss statement show? 
Why is it preferred by accountants? 

18. In making an investigation preliminary to a consolidation 
or combination, upon what specifications should the statements of 
each company be based? 

19. What special precautions should be taken to ascertain the 
correctness of the amounts claimed to represent the following assets: 
Realty; Merchandise; Patents; Bills Receivable under discount? 

20. How should the following liabilities be verified: Mortgage 
indebtedness; other indirect liabilities? 

21. What special investigation is necessary in respect to sales? 

22. Draw up a form of certificate to be made by the accountant 
conducting such an investigation. 

23. What is the provision of the English law in respect to the 
payment of dividends? 

24. Name the usual forms of fixed assets of a corporation. 

25. Under what conditions should provision be made for depre¬ 
ciation of real estate? 

26. Is goodwill a fixed or floating asset? Upon what does the 
value of goodwill depend? 

27. What are the usual forms of current or floating assets? 

28. Upon what basis should the value of stocks in hand be 
figured? Why? 


ACCOUNTING FOR MODERN CORPORATIONS 


29. Is it considered permissible to take account in a balance 
sheet of anticipated profits on contracts? Why? 

30. In estimating the value of the asset accounts and bills 
receivable, what considerations are involved? 

31. Prepare a simple form of profit and loss statement. 

32. Suppose tlie workmen, ordinarily employed in the manu¬ 
facturing operation of a corporation, are engaged in constructing an 
addition to the plant from materials carried in stock; upon what 
basis is it proper to make the charge to construction? 

33. Under what conditions is it proper to add to the cost of 
material and labor, an amount to cover expense, on construction 
work performed for itself by a corporation? 

After completing the work, add and sign the following statement: 

T hereby certify that the above work is entirely my own. 

(Signed) 




lBZ 








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